A Note About Risk

October 17, 2018

Not long ago, I attended an investment conference where Dr. David Kelly, the Chief Global Strategist and head of the Global Market Insights Strategy Team for JP Morgan was speaking. He provided some truly insightful thoughts – one of which I think is particularly prescient these days. He said, “Being a successful investor isn’t about predicting the future, it’s about seeing the present as clearly as possible.”

In recent times, it’s become seemingly more and more difficult to be able to separate fact from fiction so I thought it would be a good idea to take a look at some data regarding the market and our economic environment. Think of this as a call to notice, if not a call to action.

We at Allied Financial Partners, have been entrusted not only with the assets and investments of our clients, but also the futures on which those assets and investments will depend. As such, I felt compelled to provide some accounting of our current environment in the hopes people are not caught off guard. Please bear with me as this will be a slightly longer read. But I very much hope that you find these observations to be insightful, if not actionable. As you continue, if my forthcoming commentary causes you some concern or a desire to review your
current positioning – please contact us so that we can have a discussion about your risk positioning.

Let’s start by acknowledging some of the realities of our current economy. Remember; our economy is not the same as our financial markets and while many understand this important distinction, it’s worth mentioning that “the market” does not always act in the manner you
would expect when observing the general condition of an economy.

So how’s the economy doing? If we were to take a snapshot in time while ignoring any of the prior policies that were implemented to get us here; as well as any expectations of what our current policies may bring next – then we might be feeling pretty good when we look around. Here’s some statistical perspective:

  • Unemployment is at 3.7% as of the last reading in September (www.ncsl.org) – this is below what is historically considered full employment.
  • Wages most recently have shown growth at 3.2% (unweighted, 12-month moving average) in August (www.frbatlanta.org) – anecdotally you’re seeing Amazon and Walmart offer starting salaries at $15/hour.
  • Core Inflation has been relatively muted with August readings of 2.2% (Energy costs have risen by over 10% versus last year) (JP Morgan Guide to the Markets Q3)
  • Global Manufacturing is showing general strength in both developed and emerging market economies (JP Morgan Guide to the Markets)
  • Interest rates continue to be reasonably accommodating
  • Consumer Sentiment remains near two decade highs

This is only a very small sample of important economic metrics that are reviewed routinely as we attempt to gain insight into the overall health of both domestic and world economies. So I would suggest that the general condition of our economy is in pretty good shape.
But if we go back to what Dr. David Kelly suggests, we need to see the present as clearly as possible. So what are some of the balancing risks that we should also observe? These should be thought of as potential emerging trends that may take hold and reverse market momentum or even push us toward a more meaningful recession.

  • The Federal Reserve under Jerome Powell’s leadership has increased interest rates three times this year and indicate that more increases should be anticipated to reach a “neutral” interest rate. A neutral interest rate is theoretically neither stimulative nor restrictive to the economy.
  • There is a real threat of a global trade war taking hold. Trade wars based on tariffs essentially increase input prices around the world. These higher costs are overwhelmingly passed onto the consumer and can be seen as eroding corporate profits and consumer
    demand.
  • The level of debt outstanding both domestically and globally is concerning in an absolute sense. Increases in the costs of servicing these debts when we return to a historically normalized interest rate environment has the potential to be very disruptive.
  • Home prices have shown noticeable declines over the last 7 months as appetite for purchasing dries concurrent with mortgage rates starting to climb meaningfully.

So what has been happening over the course of the last several trading days in the markets? A quick look at some headlines recently reported by Bloomberg and CNBC is probably worth reviewing. These articles started being published in early September and continue to draw attention today:

  • “Cash Strapped Americans Are Leveraging Their Homes to Pay the Bills.” – Bloomberg 9/19/18
  • “Companies are Furiously Guiding Down Analyst Earnings Estimates.” – Bloomberg 10/3/2018
  • “The Stock Market is Trading at A Record, But A Look Under The Hood Shows Some Troubling Signs.” – CNBC 10/3/2018
  • “Two Decade Break In Stock Bond Link Signals Pain for Markets.” 10/10/2018

Additionally, as reported by CNBC, the IMF (International Monetary Fund); as recently as 10/10/2018, warns that the US Stock market is the most expensive in the world and it recommends cutting exposure to US securities.

Now, these series of headlines and underlying data points certainly paints a very different picture than what you may be feeling based on sentiment or when you have been hearing about the market hitting all-time highs earlier in September.

The reality; in my opinion, is that we are in the final stages of what has been a very long and profitable period in the markets which began as we hit market bottom in March of 2009 following the declines in 2008. We have benefitted from an unusually long period experiencing below average levels of volatility – particularly last year when we didn’t experience a single intra-day decline of more than 3%. That kind of environment should not be expected to continue indefinitely.

What most people are surprised to learn is that a healthy economy has the potential to bring about the conclusion of the business cycle. While this perhaps is contrary to our intuition, it is nonetheless what we see repeatedly. As we near the end of a business cycle: unemployment falls and businesses start competing for workers by increasing wages. These increasing wages often lead to a loss of profit as the costs of labor rise. As the costs of labor rise, those costs tend to be passed on to the consumer thus increasing their expenses. Should the consumer be reaching the limits of what their income can pay including the service of debts accumulated during the economic expansion, they will naturally begin to spend less money. Do bear in mind that our economy depends on consumer consumption. Fully 70% of our GDP is driven by consumption (JP Morgan Guide to the Markets). So if the consumer restricts their spending as a result of rising interest rates, rising costs (inflation), a loss of confidence in our institutions or a combination of these forces - then we are likely to experience a slowdown in corporate profits. A meaningful slowdown in corporate profits – driven by falling consumption combined with rising interest rates and inflation could be the catalyst that fulfills the expansionary cycle we’ve experienced these last 9 years.

The timing of this inevitable inflection point is challenging (at best) to anticipate and even the brightest stars on Wall Street cannot predict the future. Which brings me full circle: to be a successful investor, we need to see the present as clearly as possible.

In summary, I’m hopeful that this very brief look at our current economic condition; as well as a few of the balancing risks we are monitoring, will aide you in preparing for the conclusion of our current economic cycle. Risks are elevated to be sure and if our geopolitical landscape becomes more unfriendly, we may find that our lead time to the end is hastened.

Please take some time to review your current allocations and the strategies that you have deployed to navigate the market’s volatility. < span> If you’re uncertain as to how you’re positioned I would urge you to reach out and schedule a time to review. Preparing for what’s next will be paramount, even if it’s simply a matter of being prepared emotionally.

Thank you for your continued confidence and the opportunity to be a part of your team!

David A. Younis, CFP®

Director of Financial Services