Time to read: 8 minutes
At the end of this month, the current economic expansion will become the longest in our country’s history. Ten years ago people feared that the economy might never improve. Now the prevailing worry is that the music might stop.
So far, 2019 has been great for stocks and bonds; both hit all-time highs this week. And it’s justified. Interest rates are low, business optimism is high, inflation is benign, corporations are more profitable than ever, and the general feeling among consumers is positive. Moreover, market fundamentals are not stretched. The fastest-growing companies are trading at high multiples of their earnings, but most of the market is trading within historical norms.
So I found it odd that in his testimony before Congress on July 11, Federal Reserve Chairman Jerome Powell gave strong hints that a rate cut is coming. Let’s dive into this topic, as it has a big impact on the economy.
When the economy is weak, the Fed will often lower interest rates as an act of stimulus. With lower rates, businesses will borrow to expand, buy new equipment or hire new workers. Earnings get a boost as companies spend less on interest expense. Consumers also borrow to buy homes and cars, refinance mortgages and increase their lifestyle. Lower borrowing costs can increase demand, which ripples through the economy.
The concern is that all this cheaply borrowed money will drive prices higher. This is called inflation, and it’s a worrisome consequence of too much money sloshing around in the system. It’s why the Fed cannot leave rates low forever. The Fed’s goal is to stimulate the economy enough to get it going, but not so much that bubbles form or runaway inflation occurs. It’s not an easy task. Whenever the Fed hints at raising interest rates, the markets react, often violently. This is another unintended consequence of lower rates. They’re like a drug; weaning the markets off of them is not easy.
Hinting at higher rates affects both investors and consumers. Investors that once had to buy riskier assets like real estate or stocks in order to get a higher return might sell those assets and buy Treasurys if the return is attractive enough. This puts downward pressure on risk asset prices. Consumers are also impacted, as higher borrowing costs leave them with less money to spend elsewhere in the economy. This ripples through the markets and back on to consumer confidence in a negative feedback loop.
In response to the financial crisis, the Fed dropped interest rates to zero and kept them there for years. At the end of 2015, the Fed slowly began raising rates a quarter-percent at a time. And if the market didn’t like it, the Fed paused to make sure the impact wasn’t more than the economy could handle. So the Fed has a recent history of being extremely cautious in unwinding their post-crisis stimulus.
But now they’ve reversed course and are hinting at lower rates in the coming months. Why would the Fed lower interest rates with unemployment at record lows and markets at all-time highs? The consensus is that the Fed is trying to avert potential economic weakness.
In the near term, that’s good news for the markets. Cheap money is like a shot of adrenaline. But too much adrenaline can turn an otherwise healthy patient into a junkie. If the Fed gets this right, we may have a prolonged expansion as we did in the mid 1990s, the last time they last cut rates outside of a recession. But if the Fed is unable to prevent a recession, then they will have spent stimulus “ammo” too soon. At this moment, the collective opinion of the market is that the Fed will get it right and the economy will continue to expand.
But it’s important to remember that the Fed cannot hold off a recession forever. Every once in a while, an up- or down-leg goes on for a long time, as this expansion has, and people start to believe that it’s different this time—that there doesn’t have to be a recession. That continuous easing can lead to permanent prosperity. That growing deficits are not problematic. That economic strength can occur without inflation. That “disrupting” companies and stocks can thrive in the absence of profits. Or that interest rates can stay low forever.
We’ve heard many arguments for these positions in recent months. But most things will prove to be cyclical, and the economy is no exception. In every cycle, favorable developments cause people to eventually engage in behavior that is premised on overly optimistic assumptions. Once those assumptions are shown to be too rosy, the excesses correct in a period of negative growth. It will ever be thus.
We can’t say for sure when the next recession will occur. We know of no one who can consistently predict such a thing. But based on investor behavior and certain economic data, we’re likely in the later stages of the current cycle. To use a baseball analogy, it looks like we’re in the eighth inning. But the economy is not baseball. There could be nine innings or there could be nineteen. There are no rules when it comes to the economy or the markets—only a complex, adaptive system that confounds rule-makers.
So rather than build a strategy on ephemeral forecasts, we prefer to look for the known risks and opportunities and weigh them against probable outcomes. We can never know when a certain trend will turn, but we should be aware of those things that are unsustainable and position ourselves accordingly.
To that end, we’ve upgraded the quality of our fixed income holdings this quarter in response to growing risks in corporate bonds. The lowest quality tranche of “investment grade” bonds, the BBB-rated tranche, used to make up 35% of all investment-grade bonds. Now it’s over 50%, and these companies are more leveraged than ever. The loan covenants meant to protect investors have also weakened dramatically. It’s a precarious place to be this late into an economic cycle. When the economy slows, these companies will have a harder time than others, and so will their bonds. We expect a lot of these BBB-rated bonds to be downgraded to “junk” status, which will force selling and depress prices. We don’t know when that will occur, but we’re positioning ourselves defensively in advance, as we don’t feel that investors are being adequately compensated for the risks.
We design portfolios to be durable and to deliver value over the long-term. We know that markets are unpredictable over the short run, which is why we don’t create portfolios that put you at the mercy of trade negotiations, tariff talks, elections or other such ephemera. Instead, your portfolio is built to meet your long-term financial needs, regardless of market outlook. The markets won’t always give us the kind of returns we’ve seen so far this year, and at times it will require superhuman patience and discipline to stick to the plan, but ultimately a well-designed, well-executed strategy will succeed.
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