Roberts: “We Are Near The Point Where Rates Will Matter”
Bulls Push To All-Time Highs
Get out your party hats ladies and gentlemen, the markets hit all-time highs this past week.
After increasing equity exposure in portfolios on the 11th, as the markets pulled back to the previous break-out support levels, I suggested a push to new highs was likely.
“The pullback to the previous breakout support level did allow us to add further exposure to our portfolios as we said we would do last week.
(If you want to see our portfolios they are now online at RIAPRO.net.)
Next week, the market will likely try and test recent highs as bullish momentum and optimism remain high. Also, with many hedge funds lagging in performance this year, there is likely going to be a scramble to create some returns by year end. This should give some support to the rally over the next couple of months. However, as shown above, the short-term oversold condition which fueled last week’s rally has been exhausted, so it could be a bumpy ride higher.
The breakout above the January highs now puts 3000 squarely into focus for traders.”
As shown, the breakout continues to follow Pathway #2a as we laid out almost 6-weeks ago. (Next week, I will update the pathways for the rest of this year.)
While the recent rally has been useful in getting capital successfully allocated, we are still maintaining prudent management processes.
Stop-loss levels have been moved up to recent lows.
We added defensive positions to our Equity and Equity-ETF portfolios.
With yields back to 3% on the 10-year Treasury, we are looking to add additional exposure to our bond holdings.
As I noted previously, we continue to use dips in bond prices to be buyers. This is because the biggest gains over the next 5-years will come from Treasury bonds versus stocks.
This is primarily due to the analysis, I penned yesterday on interest rates:
“While the market has been rising on stronger rates of earnings growth, due primarily to tax cuts and share buybacks, that effect will begin to roll off in the months ahead. Tariffs and higher interest costs are a direct threat to bottom line profitability, particularly when combined with higher labor costs.”
“There are several important points to note in the chart above:
In the past 40-years, there have only been seven (7) other occasions where rates were this overbought. In each case, it was a great time to buy bonds and sell stocks. (When rates got oversold, it was time sell bonds and buy stocks.)
There were only two (2) other periods where rates were this extended above their long-term moving averages. The one that occurred between 1980-1982 began the long-term decline in bond prices.
Economic growth has peaked every time rates got this extended. (Which shouldn’t be a surprise.)
Whenever rates have previously pushed 2-standard deviations of their 2-year moving average – bad things have tended to occur such as the Crash of 1974, Crash of 1987, Long-Term Capital Management, Russian Debt Default, Asian Contagion, Dot.com crash, and the Financial Crisis.”
While the markets are currently ignoring the risk of higher rates, even a cursory glance at the chart above suggests that we are near the point where “rates will matter.”
Remember, credit is the “lifeblood” of the economy and with consumer credit now at record levels, and 80% of Americans vastly undersaved, think about all the ways that higher rates impact economic activity in the economy:
1) Rising interest rates raise the debt servicing requirements which reduces future spending and productive investment.
2) Rising interest rates will immediately slow the housing market taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.
3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations.
4) The “stocks are cheap based on low interest rates” argument is being removed.
5) The massive derivatives and credit markets are at risk. Much of the recovery to date has been based on suppressing interest rates to spur growth.
6) As rates increase so does the variable rate interest payments on credit cards.
7) Rising defaults on debt service will negatively impact banks.
8) Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage.
9) Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs lead to lower CapEx.
10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.
I could go on, but you get the idea.
The issue is not if, but when, the Fed hikes rates to the point that something “breaks.”
However, between now and then, the markets will likely continue to try and push higher as investor confidence continues to swell, pushing investors to take on ever increasing levels of risk, particularly as it appears as if the economy is firing on all cylinders.
But is it really?
Economic Growth Likely Fleeting
Economic data has certainly surprised to the upside in the U.S. as of late with unemployment numbers hitting lows, manufacturing measures coming in “hot,” and consumer confidence at record highs. As I discussed just recently, the RIA EOCI (Economic Output Composite Index) is near its highest level on record.
(The index is comprised of the CFNAI, ISM Composite, several Fed regional surveys, Chicago PMI, Markit Composite, PMI Composite, Economic Composite, NFIB Survey, and the LEI.)
But is this recent surge part of a broader, stronger, and sustainable economic recovery?
If you notice in the chart above, these late-stage surges in economic growth are not uncommon just prior to the onset of a recession. This is due to the cycle of confidence which tends to peak at the end of cycles, rather than the beginning. (In other words, when everything is as good as it can get, that is the point everyone goes “all in.”)
However, the most recent surge in the economic data has been the collision of tax cuts, a massive surge in deficit spending, the impact of the rebuilding following several natural disasters late last year, and most importantly, the rush by manufacturers to stock up on Chinese goods ahead of the imposition of tariffs. To wit:
“By plane, train, and sea, a frenzy has begun, resulting in surging cargo traffic at US ports, booming air freight to the US, and urgent dispatch of goods from Chinese companies earlier than planned. Getting in under the wire before Trump’s tariffs bite could mean hundreds of thousands saved on single shipments.
Bloomberg describes this week that cargo rates for Pacific transport are at a four-year high as manufacturers rush to get everything from toys to car parts to bikes into American stores.
This rush, which comes on top of a typically already busy pre-holiday season, is expected to continue well after next week as the tariff will leap from 10 to 25 percent after the new year.
US importers are expected to stockpile Chinese products before the 2019 25% mark. There’s currently widespread reports of companies scrambling to pay expedited air freight fees to dodge the new tariffs, as well as move up their orders. “
This is an important point. Not only has this been the case just recently, but since the beginning of this year when the White House began this nonsensical “trade war.”
“Of course, the most likely outcome will be a return to trade at about the same level as it was just prior to the initiation of “trade wars.” However, it will be a “return to normal,” rather than an actual improvement, but it will give the White House a “win” for solving a problem it created. “
However, this is really a tale of “two economies” as the surge in the economic data is almost solely coming from the manufacturing side of the equation. As shown, the “service” side, which is more immune to the effects of tariffs, has been declining over the past several months.
Of course, while so-called “conservative Republicans” are breaking their arms to pat themselves on the back for “getting the economy going again,” the reality is they have likely doomed the economy to another decade of sluggish growth once the short-term burst from massive deficit spending subsides. The unbridled surge in debt and deficits is set to get materially worse in the months ahead as real revenue growth is slowing.
All of this underscores the single biggest risk to your investment portfolio.
In extremely long bull market cycles, investors become “willfully blind,” to the underlying inherent risks. Or rather, it is the “hubris” of investors they are now “smarter than the market.” However, there is a growing list of ambiguities which are going unrecognized may market participants:
Growing divergences between the U.S. and abroad
Peak autos, peak housing, peak GDP.
Political instability and a crucial midterm election.
The failure of fiscal policy to ‘trickle down.’
An important pivot towards restraint in global monetary policy.
An unprecedented lack of coordination between super-powers.
Short-term note yields now eclipse the S&P dividend yield.
A record levels of private and public debt.
Near $3 trillion of covenant light and/or sub-prime corporate debt. (eerily reminiscent of the size of the subprime mortgages outstanding in 2007)
Narrowing leadership in the market.
Yes, At the moment, there certainly seems to be no need to worry.
The more the market rises, the more reinforced the belief “this time is different” becomes.
But therein lies the single biggest risk to the Fed and your portfolio.
“Bull markets” don’t die of pessimism – they die from excess optimism.