Interest Rates & Trade Wars
Welcome to the Monthly Economic Update for the month of June 2018. It’s June 27th as of the day I’m writing this article. I’m getting ready for a family break here for the 4th of July holiday. Today, the stock market reversed a 285-point gain and as of this writing we’re down about 125 points on the Dow.
If you just looked or listened to the media, you’d be led to believe that right now the only two things that matter to the stock market are trade policy and interest rates. I understand the interest rate debate, but the trade policy debate, not so much at this point. Let me explain.
When interest rates rise fixed income investments, or “safe” money, like CDs and savings accounts become more attractive to investors. I’ve talked to you about this before where if given the choice between a 5-year CD paying 6% or the stock market, many people would prefer that 5-year CD paying 6%. Now today, we can’t find that obviously. But the fear is that once interest rates get to a point high enough that it will cause an exodus from the market. Therefore, causing what are already elevated stock prices to come down and the selling will start.
Remember we talked about this last month, there hasn’t been a lot of change in the valuation of stocks since our last Monthly Economic Update. Equity valuations sit at about 110% above fair value, which is a near historic high. The only other time they were higher was in the months leading up to the Dot Com Bubble. We are significantly above, as far as valuations go, where we were prior to the Great Recession in 2008.
With the threat of rising interest rates on the horizon and equity valuations where they are today, that’s where that fear comes from. We have seen interest rates on the 10 Year Treasury eclipse 3% earlier this year. Those rates on the 10 Year Treasury have since come back down to about 2.88-2.89%. I’m still going to stand by the prediction I made in 2015 that we will end the decade somewhere between 2.5-3% on the 10 Year Treasury. I may be off a bit, and I don’t know for sure, but that’s going to be driven by money velocity.
Money velocity is what really drives inflation, too many dollars chasing too few goods. Money velocity has not really reversed course, and we’re not seeing an increase in money velocity. So, I think that the 10 Year and other longer-term treasuries are fairly stable where they are today, between that 2.5-3% range. However, the threat of rising rates from the Fed and how quickly they raise rates will actually determine how much that 10 Year goes up.
Figure 1 – U.S. Treasury – https://www.treasury.gov/
If we look at Figure 1, what we’re seeing here is treasury yields as of January 2, 2018 versus June 26, 2018. On the One-Month Treasury, we began the year at 1.29% and we are now up to 1.79%, so that’s a half percent increase in the One-Month Treasury. If we slide out to the 30 Year Treasury, we see that we were at 2.81% at the beginning of the year, we are now at 3.03%, just two-tenths of a percent increase, not even half as much of an increase as on the One-Month Treasury. The 10 Year Treasury began the year at 2.46% and is now at 2.88%, so a little over four-tenths of a percent increase there.
Figure 2 is comparing where rates were at the beginning of 2017 to today. Look at where the One-Month Treasury was, it was at 0.52% and now it’s up to 1.79%. So, we’ve seen almost a 1.3% increase in the yield on the One-Month Treasury in about 18 months. Now, if we look at the 10 Year Treasury, it went from 2.45% to 2.88%. In other words, the 10 Year Treasury from January to December last year, didn’t hardly move, we’ve just started to see that 10 Year Treasury start to increase this year. Looking at the 30 Year Treasury, it’s exactly where it was 18 months ago. That bodes well for housing and long-term loans.
As we start to see those longer-term interest rates on the right end of the yield curve creep up, that’s where the real pain will come in. There has been enough increase in the longer-term treasuries so far this year that it has put some pressure on bonds. If you were to look at the bond aggregate so far this year, it’s down about 2.25% year-to-date. In fact, most fixed-income investments, bonds or bond funds, are seeing slight losses on the year through the first six months ranging anywhere from about 1% up to as much as 4-5% depending on the duration and maturity of those bonds.
So, the interest rate debate I get, now let’s talk a little bit about this trade issue.
The media wants us to believe that we’re having an all-out trade war. That every time Trump says something it’s stamped in stone and it’s something that’s done. Instead, what’s happening today is classic negotiation 101. Trump wants something, he knows what he wants, and says he wants something far greater in order to get what he actually wants. This is causing a lot of panic in the markets. We saw it earlier this week when a false report came out about restricting investments in technology in the United States with China and other countries. That turned out not to be true, and we went from down 500 points one day, up over 100 points the next day, up 285 points the next day, and now down 125 points. It’s causing a lot of volatility in the market.
What we have to do is back up from this trade discussion and let’s look at the basic fundamentals. Our economy is strong, yes equity valuations are high, but the economy is still strong. Employment is good, for the first time in history we see more job openings than there are people actually seeking jobs today. The housing market is strong and corporate profits are up. Looking across the board we see all kinds of green lights with the economy. The one glaring red light that we have out there is the equity valuations. Then you have the threat of rising interest rates and inflation, and those two things go hand-in-hand.
We are approaching this year with extreme caution, in fact, our quarterly term indicator went negative on April 1st, however, it looks as though on July 1st that indicator will go positive, again. That would put all three of our indicators, the short, intermediate (quarterly), and long-term all into a positive outlook.
I don’t have any idea where we are going to finish this year, nobody can forecast exactly where we’re going to be. I do believe that we will continue to see volatility. I also think we’re going to see some room for positive growth this year. Our indicators will continue to keep us updated on that and we will continue to keep you updated as well. As of now, it looks like we’re going to have a positive 3rd quarter like we had a positive 2nd quarter.
Index & Sector Performance
Figure 3 – Chaikin Analytics – https://www.chaikinanalytics.com/
Let’s take a look at the month of June through the 27th in Figure 3. What I want you to notice here is that we have about a 3% spread between the best performing index, that being the SmallCap index which is up 1.35%, and the worst performing index, the Dow Jones Industrial Average which is down -1.63% so far here in June.
Figure 4 – Chaikin Analytics – https://www.chaikinanalytics.com/
Figure 4 is looking at sector performance since the beginning of June to the 27th. We can see that the gap between the best and worst performers is much wider. We see Consumer Discretionary higher by 3.21% with Industrials down 4.73% giving us an 8% spread between the best and worst performing sectors. Something interesting to note is Utilities.
Figure 5 – Chaikin Analytics – https://www.chaikinanalytics.com/
In Figure 5 we can see that early on in June, Utilities (orange line) took a real bath and was down nearly 5% in the first week or so. Now, it’s one of the better performer sectors for the month and is up 1.45%. What caused that? Well, it was the 10 Year Treasury yield dropping from what was just about 3% down to the 2.88% because Utilities are very interest rate sensitive. Real Estate is the same type of relationship and that’s why in Figure 4 you see it up about 2.27% on the month. If you were looking year-to-date on some of these sectors Utilities and Real Estate those aren’t your favorite places to be.
With all that said, I want to explain something. We are in unprecedented times on several different fronts. First of all, we have a market that is valued well beyond what it should be. That market valuation is supported heavily by the low-interest rate environment. The Fed continues talking about more aggressively raising rates. That spooks the market. Then you have all of this trade talk and tariffs and what that’s going to do. Can it cause the economy to slow? Can it put us into a recession? Could it go to a global recession? Could it cause trade wars? What other kinds of conflicts could this cause? The market is an emotional being. With valuations as high as they are, I expect to continue to see volatility.
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With that, I’m going to wish you a very happy 4th of July, I hope you enjoy time with your friends and family. I’ll be back with more information for you in about a month. Until then feel free to reach out to us and talk to your advisor about any questions you may have or anything that’s happening in your life.
Founder & CEO
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