Weekly Recap 6/15/2018: Full of Sound and Fury
by Zach Marsh on Jun 19, 2018
Calibrate Weekly Update
S&P 500 unchanged
10 Yr US Treasury unchanged
Week in Review
This week was billed as perhaps the most important economic week of the year by many in the financial media. Considering how little changed stocks and bonds were for the week, it appears to be classic hyperbolic media talk. That being said there were a number of economic events which took place this week.
First, beginning Monday/Sunday night was the highly anticipated summit between the U.S. and North Korea. Next came the interest rate decision by the Federal Reserve on Wednesday. Thursday was the European Central Bank’s interest rate decision. Markets have been awaiting clarity from Mario Draghi as to when the ECB would begin raising short term interest rates and how they will proceed with reducing their bond purchasing program.
Quantitative Easing, a program of bond purchasing by central banks around the world was introduced by the United States following the financial crisis of 2008. Europe was slow to adopt the program, but following the debt crisis in 2011, they jumped back into QE and haven’t looked back. In fact, they took it to a whole new level, buying not only government bonds, but corporate bonds as well. Anything they could buy to suppress interest rates and create an environment conducive to growth. But growth has been hard to find in Europe, and yesterday’s decision illustrated that. The ECB decided not to begin raising rates until September 2019 at the earliest, nine months after it promises to end its bond purchasing program. Draghi also promised that the September date is not a “hard” date and that they will assess the current conditions at that time.
In my opinion this could be potentially setting Europe on a path for future problems. There is an old saying that when the U.S. catches a cold, Europe gets the flu. The economic expansion in the U.S. will be entering its 109th month in July, only slightly behind the longest post-WWII expansion in U.S. history of 120 months (1991-2001). All records are meant to be broken, so there is no certainty that this record will provide an unbreakable barrier, but it is also a sign that the party maybe winding down. The Federal Reserve began raising rates back in December 2015, marking the beginning of the end of the easy money period. An interesting point about Fed rate hiking action is that, unlike an airplane, they rarely stay at a comfortable cruising altitude for long. Fed rate action typically resembles a flight from Chicago to Des Moines rather than Chicago to Beijing, the descent begins just about the time they reach maximum altitude. Before the 2008 financial crisis, the Fed maintained interest rates for only 11 months before being forced to start lowering them. In 2000, the Fed only maintained its maximum rate for 7 months. The list could go, but the point is this: the Fed ultimately succeeds in killing expansions. How long it takes the Fed to accomplish its economic assassination project varies. The expansion of the ‘90’s saw rates increase over the course of 6 years. In mid-2000’s rates only went up for a little over 2 years. In 1987 rates increase for 2 years before declining in 1989. So, it would seem that if Europe doesn’t start raising rates until late next year, almost 4 years into the U.S. rate hiking/expansion termination period, then they are considerably behind the curve.
So, what does it mean to be behind the curve? Well, it means having a smaller reservoir to pull from the next time there is an economic fire to put out. The incredible actions taken by central banks around the world have had the “unintended” consequence of exacerbating the disparity between the haves and have nots. The success of QE in spurring economic development remains up for debate, but its impact on asset prices is undeniable. Therefore, owners of assets saw a dramatic increase in net worth, while those people who don’t own stocks, bonds, property fell behind. This is not meant to be a statement of blame, just a statement of fact. Now here’s my statement of opinion: much of the political turmoil in the U.S., Europe, and around the world can be traced to this deepening divide between the haves and have nots. If the U.S. enters recession before Europe adequately raises interest rates, lacking a central government capable of fiscal stimulus, Europe could fall into existential crisis mode.
How does this impact me, you ask? We believe in assessing the risk of assets before determining the amount to allocate. Our risk assessment is quantifiable and not based upon projection of future instability, but the volatility in international markets vs U.S. markets has been historically perpetual. But others do not necessarily allocate according to risk. Many traditional advisors have subscribed to the analysis that as the U.S.’s percentage of world GDP has declined so should its percentage allocation in portfolios. We view this as naïve and potentially dangerous. Instead of leading to balanced portfolios it simply leads to riskier portfolios. Ultimately, there are many structural issues which Europe needs to address. In addition to political challenges, there are demographic problems, as well as economic problems. Consider for a second the dearth of technology companies coming out of Europe and the impact that tech companies have had on the US economy over the last 10-15 years. Thanks for reading.
Zach and Dave