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Cross Currents at Mid-Year July 7, 2014
The economy slumped in the first quarter with GDP falling 2.9%, the biggest drop in five years. But that is old news and as we said in April (“Better Times Ahead”), the economy is now recovering from the weather-impacted quarter. With less fiscal drag, and gains in manufacturing, housing, consumer spending, oil production, and employment, indicators are pointing toward a stronger GDP in the just-ended second quarter and for the second half. In turn, investors reacted positively to these signs of a stronger economy. The return on the S&P 500 Index was 7.0% for the year-to-date through June 30, with most of the gains coming in the second quarter.
In a low-yield environment investors have pushed stock prices to all-time highs with expectations that a stronger economy will boost earnings and move stock prices even higher. Institutional investors like pension funds, insurance companies and yield-hungry individual investors have pushed bond prices higher, acting on what Fed Chair Janet Yellen has been saying that interest rates will stay low for a long time. However, the indicators on her dashboard have been moving closer toward the economic, unemployment and inflation targets the Fed has set as important considerations for setting monetary policy.
As always, there are the economic nay-sayers who argue that the global economy and financial markets have become too dependent on various forms of monetary easing that has kept interest rates suppressed for the last five years. The Bank for International Settlements has warned that the search for yield has made financial markets euphoric and that central banks need to start withdrawing liquidity from the banking system and raise interest rates sooner than later to avoid unsustainable financial bubbles.
We do not subscribe to the belief that central bank quantitative easing policies have been the primary factor contributing to financial excesses and bubbles. Otherwise we would be seeing a rise in inflationary expectations and a big increase in gold prices which have been basically flat for the year to date. But however dovish the Fed and other central banks continue to be, a stronger economy with greater credit demands will put upward pressure on interest rates.
Investment portfolios should always be structured to achieve investor objectives of growth in capital values and cash flow within the framework of risk tolerances, rather than trying to outguess short-term moves in the market. That involves an assessment of the impact of developing macroeconomic trends as well as the suitability and expected returns of individual investments.
The rise in bond prices has to be a concern for investors who might normally have an allocation to fixed income investments. With yields so low at the present time some investors have been moving out of bonds entirely while institutional investors and others who need income and have long term horizons have been extending maturities and selectively taking on more credit risk to get some returns. At current prices income returns are very low and when interest rates eventually rise it will be difficult for bonds to provide a positive real rate of return.
If investors focus only on the short-term, they will never have any clarity for the investment outlook. Very little of the short-term ups and downs in the market have anything to do with reported news; it’s mostly emotional. Over the long-term the market for stocks will reflect underlying financials and investor preferences in the expected business environment.
At the present time our perspective is that stocks are fairly valued on an historical basis and attractive relative to bonds and other alternatives. Prudent investors always have to develop a tolerance for volatility in what can be a volatile investment environment, own a diversified portfolio of investments designed for the long term, and have the patience to let time be their most valuable ally.
We hope you have a great summer!
Note: We have gathered the information contained in this report from sources we believe reliable; however, we do not guarantee the accuracy or completeness of such information. You should not assume that any discussion or information contained in this market commentary serves as the receipt of or as a substitute for personalized investment advice from Whitnell & Co. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.