Heading For New Highs... For Now

Summary

Markets have broken out, so adding equity exposure for the short-term may help boost returns.

Inflation is not likely to spike, so bond returns should be "okay" going forward.

The market is changing, and we are entering the beginning of the end for the current cycle.

We are starting to see end-cycle dynamics play out with a potential spike in commodity prices causing a reverberating effect that could cause a global slowdown.

Introduction

We have written many missives over the last year discussing how the low-volatility environment and the areas of strong returns were not likely to last. REITs and energy have been in the doghouse but surprisingly, the same could be said for health care and consumer staples sectors. Meanwhile, there is nothing stopping the FANG stocks as it appears to be 1999 all over again.

Market leadership can be the best indicator of inflection points within the market itself. While we feel a recession is likely more than a year away, there are several moves we think investors should be making today to take advantage of the last leg of the bull market.

Attempting to time the end of the cycle is extremely difficult, which we liken to market timing. However, we can make small adjustments along the edges using data publicly available to prepare the portfolio.

Aside from duration, which we think is a useless factor in terms of predicting cycles, there is analysis we do to position the portfolio within not only the correct asset classes but subsectors in those asset classes as well.

Markets Are Turning

From the interim bottom in early 2016, stocks have gone up almost unimpeded with the S&P 500 - (SPY) rising from ~1,800 to over 2,872, an increase of nearly 60%.

 

 

 

^SPX data by YCharts

 

What is to power markets higher?

We do not think that is increased earnings, as the majority of pundits will state as being the catalyst. The earnings reaction in the first quarter season has been strong earnings beats coupled with lackluster responses from the market. We believe that market is discounting the benefit that these companies are receiving from the tax reform bill recently passed by Congress.

 

What Are The Potential Bumps In The Road To New Highs?

Here we analyze a few factors that we think investors need to keep an eye on when allocating capital. We highlight four variables that are all interrelated and can influence each other but that each has their own factors that drive their returns.

1 - Interest Rate Spike

Interest rates continue to market higher, both on the short end and the long end of the curve. While the short end is rising faster than the long end due to central bank intervention, the long end is moving as well after consolidating just below 3%. The next stop is 3.25%, which is not a technical level but more of a psychological one.

On a yield basis, we think Treasuries are starting to become attractive, especially to institutions like pension funds who utilize them for asset-liability matching. The 10-yr over 3% is now much more attractive than the dividend yield on the S&P 500. We believe the main driver of the lower bond prices is sentiment on the expectations of higher inflation. But what if that inflation bump is transitory?

 

Rate-sensitive sectors like utilities, consumer staples, and REITs have been under pressure for most of 2018. Dividend-paying stocks are long duration plays, especially when those stocks have little in the way of earnings growth, as is the case for utilities and consumer staples. While we are long-term bearish on the former (thinking energy in the future will be close to free), we think the latter is beginning to look compelling from a valuation standpoint.

 

 

 

XLU data by YCharts

 

One thing we are considering is that the 10-year is breaking on technical but that the fundamentals could drive it back down. One of those fundamental factors would be lower inflation expectations, primarily from a drop in oil prices. Another the rising dollar, mentioned above, that could increase the breakevens on foreign risk-free investment. In other words, German investors could swap from investing in 10-year bunds at 53 bps and invest at 309 bps using US Treasuries and then hedge the currency risk. With a rising dollar, that currency hedging becomes less expensive.

We are also seeing a bit of a gap between the 10-year yield (white line below) compared to the copper/gold ratio (orange line). That gap is likely to close, which we think will be driven by a combination of lower yields and higher copper prices.

 

2 - Inflationary Spike

Inflation has been something that is right around the corner for some time, similar to higher interest rates. But the two are CLEARLY correlated. You often cannot have one without the other.

U.S. CPI has been on an uptrend since late 2015. However, this measure is highly correlated to the price of gasoline. Crude oil prices have risen over that time period by over 150%.

 

Market-based inflation expectations are also HIGHLY correlated to the price of crude oil. As oil moves up, inflation expectations move up as well. The price of oil today could be a transitory event not predicated on higher demand but due to geopolitical events. One of those events is getting out of the Iran deal which will mean less oil on the global market. Another is the devastation in Venezuela, which has one of the largest proven reserves of any country in the world. So far, 900K barrels per day have been taken offline in that country and that number is likely to rise.

 

But one of the leading factors towards higher inflation is wages. With an unemployment rate below 4%, wage inflation is a key factor to watch. Typically wage inflation doesn't translate into significant CPI inflation until it exceeds 4%. Recent data suggest that the wage growth is slowing a bit.

 

Meanwhile, the growth in M2 money supply continues to decline which shows no increase in bank lending. This is a headwind for inflation.

 

While inflation is likely to head higher in the near-term, we do not foresee anything that would cause us to see a massive spike in inflation, as we have in previous expansions. Increasing prices is a natural by-product of later cycles, as is rising commodity prices. Are we in an inflationary period of ever-rising prices? Or are we simply just moving away from the deflationary period that characterized the 2012-2016 period?

3 - Commodity Spike

Most precious metals continue to not work in this market despite the rise in oil prices and other commodities. Commodities have been dead money for a long time. Most investors focus squarely on the price of oil, but these different commodity baskets do not move in lock-step.

 

 

 

^SG3J data by YCharts

 

Precious metals are a great hedge against inflation. Obviously, most investors know that gold has been a store of value for hundreds of years- and especially since the advent of fiat currencies. If that is the case, why isn't gold and other precious metals rising in value?

The prices of stocks of most commodity firms have underperformed the rebound in price of the underlying commodity itself. This is no more apparent than in the MLP space. Crude prices have broken out of the $40-$50 range where a barrel of oil was for over a year and have moved higher unimpeded. At the same time, MLPs have moved lower in price. (more on this below)

 

The dollar has been on the rise in 2018 bucking most forecasts we have seen. When the new tax bill passed in late 2017 it was assumed that the large jump in fiscal deficit spending would send the dollar in a downward spiral, perhaps faster than it already was reeling. However, never underestimate Mr. Market from causing the most amount of pain to the most amount of people.

 

4 - Emerging Markets

In 2017, emerging markets and international developed markets were the big winners. The MSCI EM Index returned 36.42% last year aided by a falling dollar and some better growth prospects. This was a significant change from prior years when the index was down 3% in 2013, 4% in 2014, and 15.4% in 2015.

Developed markets also did well, again aided by a falling dollar but also the first signs for life from Europe. Valuations outside of the U.S. have been far cheaper as the MSCI AC Ex-U.S. index hasn't moved up nearly as much as the S&P 500.

 

The 'boom' globally in 2017 was likely more sentiment driven. We did have some traction in underlying economic growth in places that it had been lacking, namely Western Europe, parts of Asia like Japan, and especially in Latin America. However, some of that growth spurt appears to be waning, especially in developing markets and Europe.

In 2018, that has all changed. The catalyst? A rising dollar.

The dollar bottomed in late January and as we noted in a recent blog post, is the new downside protector given rising interest rates and the effects on bond yields. The Dollar index is now over 93, a sharp move higher that is showing no signs of stopping.

 

 

 

^DXY data by YCharts

 

Noted Harvard Economist Carmen Reinhart surprised many people this week by stating emerging markets are in worse shape now than they were in 2008. The running thesis had been that the majority of EM countries were in better shape through less debt-to-GDP ratios and stronger, more diversified economies.

But debt has been climbing quickly over the last five years from about 37% to now over 50%.

 

The main issue is the current accounts of EM countries going from significant surpluses just after the recession to falling into deficits in 2017.

Conclusion

The S&P 500 has broken out of their consolidation phase and we believe is poised for new highs. Many of the overhangs that sowed the seeds of the correction are in the past including the potential "trade wars". The rising dollar could produce more investing domestically, which is why we have seen the small-cap index already hit new highs.

But ultimately, we do think that higher oil prices will translate into higher interest rates and could ultimately stall the recovery. The media pundits all keep asking guests about the level the 10-year yield needs to get to before it "starts affecting stock prices." We think that is the wrong question to ask. The right question is when higher rates start affecting the economy. The average corporate balance sheet today is much more highly levered than ten years ago. In addition, much of that debt is now floating rate, meaning that as rates rise, interest expense rises with a small lag (typically 90 days).

We run through several of the factors that we think investors should have an eye on the near-term. The main factor that almost no one saw coming has been a rising dollar. With oil and rising in tandem, one will likely have to give and reverse course.

We are currently looking at our Core Income Portfolio for exposures to the energy segment as well as the domestic vs. international allocation. While higher rates are likely which will produce some paper losses in our portfolio, over time, the cash flows tend to overwhelm those losses. Additionally, there is a maturity wave that is flowing through the corporate bond market over the next two years. For the first time, it is possible that many of these rolls (old bond matures, and a new bond is issued to pay off the old one) will result in a higher coupon, something that hasn't been the case for a long time.

Our income production is likely to also start realizing less in the way of distribution cuts and more in the way of flat to even distribution increases over the next couple of years.

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