Thoughts on the Current Outlook

Three Key Thoughts:

  •     Big rally in credit continues

  •     Central banks stay at center stage

  •     Slow growth begets low returns

The positive tone of the financial markets that kicked off in mid-February continued through the third quarter.  US stocks ended the quarter near historical highs, helped by a mid-September decision by the Federal Reserve not to raise short term interest rates.  With an accommodative Fed, decent economic growth and steady oil prices, prices on corporate bonds rallied strongly, while US Treasury yields stayed relatively stable. 

International stocks rose more than their US counterparts in the third quarter as investors realized that Brexit implementation is going to take several years.  In addition, scares about capital flight and slow economic growth in China subsided for now.  

The Federal Reserve surprised almost no one by not raising rates in mid-September.  Still, investors’ nerves were calmed, even though the Fed made it clear that it could raise rates at any upcoming meeting.  December now seems like a likely choice but the markets remain somewhat skeptical.  Just as the Fed has earned a reputation for being too positive about future economic growth, it is also earning a reputation for being easily derailed from hiking rates by events unrelated to the US labor market and inflation.  Meanwhile, the US labor market continues to gain strength and inflation is beginning to appear.  We think the Fed now risks getting behind the curve and having to hike more quickly than it would like next year.  

The central banks of Europe and Japan are trying to strongly encourage growth and inflation, with relatively little success.  In Europe, the central bank continued its asset purchase plan, similar to the quantitative easing we had here in the US, except that their plan includes a broader range of bond types.  In recent days, concerns have arisen about Deutsche Bank’s capital adequacy, if it is required to pay large fines to settle with the US government over mortgage crisis transgressions.  This will pose an interesting dilemma for the German government, as a 2008-like bailout is politically untenable.  

In Japan, negative rates are still in effect and attention has gradually been shifting toward more creative ways to generate growth and inflation.  So far, nothing has broken the long-ingrained expectations of falling prices and a stagnant economy.  

With stock prices going up while earnings are flat, investors are paying pretty high prices for future earnings, particularly here in the US.  This may be okay so long as interest rates are stable and earnings begin to grow.  But if longer term rates were to start rising with inflation expectations, the prices that investors are willing to pay for stocks may tumble.  Particularly vulnerable, we believe, are high dividend, low growth stocks that have been bid up for their dividend yields.  These normally defensive stocks could be much less stable during the next market decline.  

As the market gains clarity about the US presidential election, it would be typical to see a rally in stocks between now and year end.  However, the new president will face a long list of problems that have been left unattended because of the unwillingness to compromise from either side.  We can only hope that the new president takes a constructive path forward, working with Congress to address some of the nations problems.  

Our core views about the outlook for the financial markets remain unchanged.  

Global growth will be slow.  The EU was already in slow growth mode and Brexit confirms that there will be no breakout to the upside soon.  China’s growth rate is coming down but the base is now large enough for it to still be a major contributor to global growth.  We continue to believe that the US is stuck in a 1-2% real growth economy for some time to come.   The first two quarters of 2016 have confirmed that trend.   

Interest rates will stay lower for longer.  Interest rates in the US may rise a bit as wage inflation makes an appearance but will be held down on the short end by a reluctant Federal Reserve and on the long end by lower yields available on sovereign debt in Europe and Japan.  

Positive investment returns will be hard to find.  We are neutral on US large cap stocks while staying negative on US small caps.  Outside the US, we favor a mix of carefully selected active stock fund managers, including those with dedicated emerging market and Asia exposures.  The hedged strategy portion of most portfolios is relatively large as we maintain our underweights to bonds and US small cap.  In most portfolios, we initiated a small position in a diversified commodity basket as an inflation hedge.  Despite these shadings in our investment allocations, we still aren’t excited about any asset class right now.  

We will summarize by reiterating that we see lots of potential sources of volatility and not many sources of great prospective returns.  This combination of low expected future returns and high risk is not a hospitable environment for investors.  We are emphasizing a broad diversity of strategies in client portfolios and expect to use volatility to clients’ advantage when we believe it is appropriate.  


October 7, 2016                © Essential Investment Partners, LLC             All Rights Reserved