Is This Time Any Different?
George Santayana, a Harvard Professor in the first half of the 20th century, is credited with coining the phrase 'Those who cannot remember the past are condemned to repeat it.’ For any profession, competency is gained from knowledge, experience and, to some degree, remembering and learning from the past.
As we study the economy and the relationship it has with markets, we ask whether this time is different. Our short answer: it is, but future results may not be.
The absolute level of interest rates is a major influence on economic activity and markets in the short‐term. With its dual mandate of price stability (2% target for inflation) and full employment, the Fed targets a short‐term rate to stimulate the economy by lowering rates or raising rates to keep excessive inflation at bay.
Going back to the early 1980s Fed Chair Paul Volcker embraced a policy to rid the US economy of inflation and drove short‐term rates to as high as 18% for a short period. Over the subsequent four decades inflation has steadily declined and for the last ten years has been nearly non‐existent according to government statistics. With global economies reeling from the financial excess and abuse of the late 2000s the Fed took unprecedented action and lowered rates to nearly zero for more than six years. In late 2015 the Fed began its long process of raising rates up to something that resembles ‘normal’. This process came to a halt last December after the ninth rate increase of the cycle. Up until late last summer markets were anticipating four more increases stretching through 2019.
Fast‐forward nine months and markets now price in up to four cuts over the next twelve months. The Fed’s concern has turned from excess inflation to slowing growth.
With an accommodative Fed, investors and businesses alike remain optimistic knowing policy makers will be supportive. On a high level this provides support for today’s equity valuations and future growth prospects. The European Central Bank has also recently stated that it will do whatever it takes to support economic growth within its region. Many pundits predict a recession in 2020 and point to the fact that we are long overdue for one. We, on the other hand, do not believe that a recession must occur every four to seven years as some sort of natural cycle. Australia, for example, is on year 28 (!) of continued expansion. That is right, their economy did not contract during the Great Recession.
The Fed has access to the most robust data available in order to make the best decisions for the short‐term and long‐term. It also does an excellent job communicating its intentions well in advance so that markets are not surprised by its actions. This leads to greater stability in markets and supports higher equity valuations.
In light of recent events we have adjusted our return expectations for the remainder of the year for both equity and credit. With the surprising strength of the bond market due to the outlook for lower rates we see limited upside from here. The benchmark 10‐Year Treasury Note ended the quarter to yield just over 2.00%, a level not seen since late 2016. This market has already priced in three rate cuts by year‐end. This leaves us with a 1% return expectation for the remainder of the year coming from interest only. Should these rate cuts not materialize we expect rates will rise,negatively impacting safe money.
Equities added to their stellar first quarter returns in two of the months during the second quarter, May being the holdout with a decline of more than 6%. Year‐to‐date the S&P 500 Index has added 18%, but it is important to remember that the end of last year erased all the gains and then some for 2018. After nine months, the US equity market is about where it was at the end of September 2018. We envision continued gains here due mainly to accommodative central bank policies. An additional 5% gain by year‐end would cap 2019 as a ‘top ten’ year for US equity investors and far exceed our expectations set in January.
The truth is that economic growth is a marathon, not a sprint. And the higher returns we experience today, the more muted returns are likely to be in the future. Should interest rate cuts not materialize, rates will surely bound higher and valuations will compress, leading to headwinds for equities.
We remain most enthusiastic about opportunities in private companies and funds. The premium that we earn for investing in less liquid, private markets remains compelling.
We look forward to sharing our updated thoughts with you in the fall.
As always, please reach out to continue the conversation
-SAVE THE DATE: EPIQ Clambake, Thursday, September 26th-
With guest speakers Gene Munster of LOUP Ventures and Jim Robillard of Spyglass Capital Management: