Third Quarter 2017

Last January, most investors thought fiscal policy would overtake monetary policy as the driving force behind economic expansion.  Also, they thought inflation and interest rates would creep up.    By mid-year, expansionary fiscal policy was nowhere in sight, and inflation and interest rates remained tame.




% Change

Dow Jones Industrial Average (DJIA)



↑ 8.0%

Standard & Poor’s 500 Index (SPX)



↑ 8.2%

NASDAQ Composite Index  (COMP)



↑ 14.1%

Russell 2000 Index (RUT)



↑ 4.3%

Federal Funds




10Y US Treasury Bond




30Y US Treasury Bond




London Gold PM



↑ 8.4  %

Remember, when bonds yields rise, bond prices fall (and vice versa).

Investors thought wrong.  But, the stock markets performed well because:

  • Global and domestic economies improved.  As the world’s four largest central banks boosted liquidity (and pushed interest rates down), most developed countries saw strong economic expansion including manufacturing and export activity. Also, as political uncertainty in the Eurozone abated, business and consumer confidence rebounded.  Growing global demand for U.S. products and services resulted in surprisingly strong corporate profits.
  • Inflation and interest rates remained low.  In June, the Consumer Price Index (CPI-U) rose a scant 1.6%, well below the Fed’s 2% target range.  Continued liquidity combined with lower oil prices and shelter costs appeared to offset the financial impact of a tightening labor market.  Although the Fed started normalizing rates, low inflation underscored that the process will be gradual.
  • The U.S. dollar weakened.  After the Trump victory in November, the U.S. dollar surged as investors assumed an aggressive fiscal agenda was imminent.  But, it weakened after the agenda faltered and overseas economies strengthened.  A weaker dollar makes our goods and services more affordable for overseas buyers.  In turn, this means more export sales and profits for U.S. companies.

For now, we believe these trends remain solid.  But, we wonder if tiny cracks are emerging that will impact the economy and markets down the road.  Here are our thoughts along those lines.

  • This expansion is long in the tooth.  At 96 consecutive months, it is the third longest expansion since World War II.  This alone is not a concern, but economies do not expand in perpetuity.  Economic shocks and recessions happen, and no one “rings the bell” at the top.
  • Unemployment hit a 16-year low.  With unemployment comfortably below 4.7%, we have a full employment economy.  This means companies must compete for talent by increasing wages and benefits.  In turn, this creates inflationary pressure and it is a primary reason the Fed has committed to normalizing rates.
  • Consumer confidence hit a 16-year high, too.  When consumer confidence is high, asset prices (like home and stock prices) move higher.  In turn, the higher asset prices boost consumer confidence further.  On an historical basis, this leads to increased risk taking and borrowing, neither of which end well for the consumer.
  • Investors are complacent.  The Chicago Board Options Exchange Volatility Index or “VIX” is one measure used to gauge investor fear and complacency.   While a high reading suggests fear, a low reading suggests complacency.  Recently, the VIX traded below 10% for the first time in its history.  Shocks to the market are largest when complacency is low.
  • The Fed is shrinking its balance sheet.  During the 2008-09 financial crisis, the Fed launched an aggressive Quantitative Easing (QE) program.  In effect, it “printed money”, then used it to buy bonds from its member banks.  By creating this artificial demand for bonds, it moved their prices up and interest rates down.  In theory, this infused banks with cash, allowing them to make low interest loans to jump start the economy.  The effectiveness of QE is controversial.

As the Fed implemented QE, its balance sheet ballooned from $860 billion to $4.5 trillion.  Recently, it announced plans to shrink its balance sheet by no longer replacing bonds at maturity.  By removing the artificial demand for bonds, it moves their prices down and interest rates up.  To date, this is not well-recognized in the marketplace.

  • Hyman Minsky’s financial instability hypothesis is in play.  Stating that financial stability begets financial instability, it goes something like this.

When the economy is stable, people become optimistic.  The economy has expanded for 96 months.  People are optimistic and driving up asset prices, like home and stock prices.  In turn, they become more optimistic and drive prices higher still.

When people are optimistic, they accumulate debt.  In March, U.S. household debt levels topped $12.73 trillion, surpassing the 2008 peak of $12.68 trillion.  Currently, credit quality is fairly high and delinquencies are fairly low, but this will change.  As optimism and asset prices rise, lenders make riskier loans and borrowers accumulate debt beyond their means.

When people take on debt, this inherently makes the economy unstable.  Asset bubbles and speculative lending are not sustainable.  Sooner or later, we will have a  “Minsky moment” when the bubble bursts and the economy becomes unstable.

Current Outlook

Current trends bode well for equity returns.  Although valuations are somewhat rich by historic standards, they are less so when viewed in terms of the global economic expansion, low inflation and interest rates, and strong corporate profits.

Potential fixed income returns are less clear.  On the one hand, interest rates are rising based on the Fed’s stated intent to normalize interest rates and shrink its balance sheet.  On the other hand, this may (or may not) take a while.  This begs the question.  Should investors buy short-term bonds, earning a lower yield but preserving their principal as rates rise?  Or, should they buy long-term bonds, earning a higher yield but risking their principal?

As you consider the question, keep this key principle in mind.  When interest rates go up, bond prices go down.  And, long-term bonds are far more vulnerable than short-term bonds.  Specifically, if rates rise by 1%, a bond will fall by 1% for every year of its duration.  So, if they rise by 1%, a bond with a 2-year duration will fall by 2% whereas a bond with a 10-year duration will fall by 10%.

Now, here is how we answer the question.  For now, investors are not getting paid to buy long-term bonds based on an historical assessment of the “10/2 spread” (the difference between the 10-year and 2-year Treasury bond yields).  As of June 30, 2017, the 10/2 spread was 0.93%[1].  So, an investor who bought a 10-year Treasury would be paid less than 1% per year for buying a bond with a maturity five times longer than the 2-year Treasury.  That is not much, especially when the Fed has committed to normalizing rates and shrinking its balance sheet, and you consider the math above.


[1] As of 06/30/2017, the 2-year and 10-year Treasury yields were 1.38% and 2.31%, respectively.  Source:  Daily Yield Curve Rates, U.S. Department of the Treasury.  



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