Head Winds
For the capital markets, the second quarter of this year was very much like the first quarter. Equity markets were volatile and ended up close to where they started, at least on the domestic side. Bonds continued to struggle as interest rates moved higher. Global stocks and emerging market stocks sold off as worries rose about the state of the global economy. In the U.S., fears of higher inflation combined with worries over free trade, causing investors to fear that the nine-year economic expansion may be in danger. The yield curve has become very flat, meaning there is not much different between short term and long term interest rates. This is rarely a good sign for the markets.For the capital markets, the second quarter of this year was very much like the first quarter. Equity markets were volatile and ended up close to where they started, at least on the domestic side. Bonds continued to struggle as interest rates moved higher. Global stocks and emerging market stocks sold off as worries rose about the state of the global economy. In the U.S., fears of higher inflation combined with worries over free trade, causing investors to fear that the nine-year economic expansion may be in danger. The yield curve has become very flat, meaning there is not much different between short term and long term interest rates. This is rarely a good sign for the markets.
There remains much positive economic news. In the U.S., consumer sentiment remains high. Home prices are strong, and the unemployment rate dropped to 3.8% in May. The average hourly earnings rate rose 2.7% in the past year and corporate earnings are rising.
With all of this great economic news the question arises, “Why are the capital markets struggling?” To answer this, we must look beyond the numbers. The unemployment rate is well below the natural rate of unemployment. With a tight labor market wages rise, which we have seen over the past couple of years. Higher wages are passed through to the consumer in higher prices, increasing inflation. High home prices force households to spend money on a mortgage payment that would otherwise be spent other places. This can continue as long as consumers are optimistic about the future, but once they start to pull back their spending, economic growth can slow rapidly, bringing down earnings and the markets.
There is sometimes a disconnect between the markets and the economy. For example, the best time to buy stocks in the past thirty years was the Spring of 2009, when the economy was terrible. The best time to sell stocks in the past thirty years was the Spring of 2000, when the economy was fantastic. In bad economic times, pessimistic investors drive prices lower than they should be, and in good economic times, optimistic investors drive prices higher than they should be. This has been going on for hundreds of years and as long as there have been investors and investment opportunities. The good news is that while stock prices are high right now relative to earnings, they are not close to the levels seen in 2000. And if we do experience a recession and a corresponding sell off in the capital markets, it is very unlikely to be as nearly as bad as it was in 2008.
From a business and economic standpoint, the world has become a very small place. All the world’s economies are interconnected as never before. Economic difficulties are shared across the globe and are not isolated in one or two places. Economic growth is also shared. Economic policies that help the rest of the world also help U.S. businesses and consumers. We are all in this together. American business benefits greatly from free trade and our hope is we back away from the protectionist talk in Washington.
Wabash Capital
