WE Invest

October 11, 2018


A term referencing a fighter pilots’ position and checking your rear, or 6 o’clock position for the enemy. Watch your back, watch your six or just check-6 is quite fitting today. There are many risks brewing and it takes historical context and patience to invest in these markets.

Quick take-aways:

  • The US Economy is hot. Is it too hot?
  • Will inflation and higher rates hurt profitability?
  • International equity has dogged portfolios and global allocators? Will it end?
  • Our bond portfolio has done well on a relative basis and helped overall performance in a very tough bond market. What’s next?

Uncertainty resumes. While its easy to be bullish on the US economy, looming risks persist. As the fed and global central banks gradually remove monetary accommodations the risk of a mistake increases. Nothing highlights that uncertainty like Fed Chair Jerome Powell’s October 3rd “long-way from neutral” and "We may go past neutral, but we're a long way from neutral at this point, probably" comments. This left traders uneasy, contemplating there might be more rate hikes than previously expected in the near term.

If you sneezed you might have missed last week’s spike in yields, and you might have missed the gradual rise in yields across the short end of the curve or short-term bonds. While the latter was expected, this week’s move in longer term bond yields was dramatic. The increase in short term rates has made investing in cash alternatives more attractive than it has been since shortly after the Great Recession.

Friday morning’s job report (10/5/2018) was another boost to yields as job creation fell, yet the unemployment rate still fell, reaching nearly a 50-year low of 3.7%. In response, the yield on the benchmark 10-year Treasury note hit levels not seen since May 2011 of 3.233 percent immediately following the jobs report (remember bond yields are inverse to prices so as yields go up bond prices fall). Average hourly earnings rose 8 cents or 0.3 percent month over month bringing the year-over-year increase in wages to 2.8 percent. This hints at an acceleration in wage growth.

Are we at or near full employment, will wages continue to accelerate? Will the Fed make a mistake and over/under correct with rate hikes? Was the Tax Cut a great idea just at the wrong time in the business cycle? To know the answer is to speculate but the market concern is that the likely answer in my opinion is – Yes.

Junk bonds (aka high yield bonds), rated below investment grade, are attractive only in that there is a very low risk of default, but spreads (the spread is the difference between the two yields) are extremely unattractive. While most advisors keep pouring into high-yield we have mostly stayed away and are underweight. Spreads are very tight hitting 3161 basis points on 10/03/2018 or 3.16% over the 10-year US Treasury yield. The historic average is between 585 and 4871 basis points and the index had spent 2/3 of the time above 6001. The low point was hit in 2007 at 2711. This is generally a good sign because it shows appetite for risk, but it also shows signs of greed and complacency.

Another perspective on the 10-year US treasury is its spread to the German bund which keeps getting wider. This seems unsustainable. Either way it pushes more money from around the world to buy the US Treasury which provides downward pressure and limits its rise much higher.

Oil has made a screaming come back. You likely noticed on your recent fill up at the pump. This is a negative for growth. There are concerns that Brent, the benchmark for half of the world’s crude, may hit $100-a-barrel. On the other side of that bet there is relief that Saudi Arabia is committing to fill the gap left by Iranian Oil.

2018 has seemingly been a terrible year for global asset allocators. For example, the S&P 500 is up 7.93%YTD and 13.07% over 12 months (as of 10/05/201). If you look at Morningstar’s Moderate Target Risk TR allocation benchmark which is allocated across US, International equities and bonds was up YTD .71% and 3.79% over 12 months (as of 10/05/2018). While it seems clear to me we would have been better off only owning US equities there appears to be much more value in Europe, Japan, and Emerging markets. Unfortunately, the constant tariff rhetoric, oil near a 4-year high, and a strengthening dollar since April has made those markets seem to be poor investments. While we aren’t ready to overweight international markets yet, we will if the conditions improve, as these markets have a tendency to provide great opportunities. For example, last year (2017) the MSCI emerging markets index was up 37.28%.

The 4th quarter begins with recessionary threats very low in the near term, a strong earnings outlook, and projected high single digit equity market returns through 2019. We believe our greatest threats include; the deficit, tax cuts wearing off, US Treasury above 3.5%, inflation acceleration, tariffs and protectionism, and Oil approaching $100.

As you may know we always focus on preservation first and growth second. We transition into 2019 looking forward but always checking our 6.

1 https://indices.theice.com/getQuickChart?index=H0A0&currency=USD#

Any opinions are those of Eddy Augsten and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. There is no assurance any of the trends mentioned will continue or forecasts will occur. Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. Junk bond, or high-yield, is a bond that is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors. High-yield bonds are not suitable for all investors. When appropriate, these bonds should only comprise a modest portion of your portfolio. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Commodities and currencies investing are generally considered speculative because of the significant potential for investment loss. Commodities trading is generally considered speculative because of the significant potential for investment loss. Among the factors that could affect the value of the fund's investments in commodities are cyclical economic conditions, sudden political events, changes in sectors affecting a particular industry or commodity, and adverse international monetary policies. Markets for currencies, and precious metals and other commodities are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. Though they can mitigate risk in a portfolio, diversification and asset allocation do not ensure a profit or protect against a loss. The S&P 500 is an unmanaged index of 500 widely held stocks that's generally considered representative of the U.S. stock market. MSCI Emerging Markets Index is designed to measure equity market performance in 23 emerging market countries. The index's three largest industries are materials, energy, and banks. Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary.

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