April was a busy month and the spotlight was firmly on the Fed, earnings growth and North Korea. Starting with the Fed, they decided to leave rates unchanged and while continuing to signal more increases are coming, and soon. They see inflation increasing in the near term which is inevitable with oil prices having risen so much. The way inflation is measured if oil was at $55 and now at $70, that’s a 27% year over year increase. A research report I recently received believes headline inflation will be around 3% by the summer, but core CPI won’t nearly be that high. The yield curve has continued to flatten this year and we’re starting to see almost daily reports discussing the possibility of an inverted yield curve (when the yield on short term bonds is higher than long term bonds discussed more below). As it’s been mentioned in previous monthly updates, there have been 14 recessions since the Fed was created. There have been 11 tightening cycles which coincided with 11 recessions (100% success rate or failure depending on how you look at it) and 3 were unrelated to interest rates. We’ll see where we end up this time around as it’s too early to call.
Earnings have been strong for Q1 which wasn’t a big surprise since a lot was related to the tax cuts. All of the numbers aren’t out yet and earnings so far appear to be 20% higher. If this pace continues for the rest of 2018 and markets stay flat, valuations will have dropped by 20% which is a big deal. The earnings multiple (past and forward looking) was very inflated relative to historical levels. Even a 20% decrease in valuations still has us above average, but certainly not in the bubble territory we were in. If we have a few years of earnings growth like we’re having along with low single digit equity returns, US index valuations will have move back down to a very reasonable level and even below the long term trend.
There’s still a lot of uncertainty geopolitically related to trade wars, although a North Korean summit has taken full stage. It’s difficult to tell whether this is a gambit by Kim Jong Un, but recently met with South Korean President Moon Jae-in and agreed to finally end a seven-decade war this year, and pursue the “complete denuclearization” of the Korean Peninsula. That’s a big deal!
My 2 Cents:
I think it’s possible that we see an inverted yield curve late this year/early next year if the Fed raises rates 3-4 times. If the Fed funds rate increases by .75-1% and the 10 year/30 year treasury bond yields only increase marginally, this would be enough to invert the curve. The 10/30 year treasury bonds are influenced by longer term growth and inflation expectations and the bond market is currently saying they don’t believe we’ll have meaningful growth or inflation for the long term. Short term (as referenced above), inflation should increase given the Fed more than enough reasons to continue increasing rates at their current pace. The 10 year treasury recently touched 3% for the first time since 2014 and the trend of falling 10 year treasury yields since the 80’s may be temporarily over. If you own bonds in your portfolio, the important factors are: average coupon, duration, maturity and credit quality. With short term yields having risen, it’s hard to justify buying a 30 year treasury bond and earning 3.2% when you could own a money market at 1.8% and not take any risk. Keep in mind if the 30 year bond yield jumps 1%, you’ve lost around 18%. Not a great risk/reward.
Do you know what’s in your bond portfolio?
Charts & Commentary
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