September 12, 2017

L&S Risk Pulse™ Score

Medium +

Core economic indicators are healthy, but markets indicate potential near-term volatility and/or mild correction. Valuations are trending high.

L&S Risk Pulse™ Insights – “Suppose They Gave a War and Nobody Came”

General Comments

Suppose at the end of last month we told you that August would bring about a North Korean ICBM threateningly launched over Japan; the U.S. Government would portend to shut down over the budget deficit and President Trump’s desire to have Americans pay for the border wall; a hurricane would flood another large American city; racial riots would break out in Virginia, and the President would suggest that all parties were to blame.  These actual events, combined with the knowledge that August is typically one of the weakest months of the year, would suggest that we would be in for a significant market correction.

In actual fact, the market shrugged off all of those events and was roughly flat for the month.  There was an act of war and nobody cared.  It does surprise us that the market has been so resilient, and perhaps there are even some logical explanations.  As belligerent as Kim Jong Un is, North Korea may be angling for some financial aid rather than outright war.  Perhaps Kim realizes that war with the West and with China is unwinnable.  He may land a solid punch, but then it would be lights out.  Instead, by provoking the supreme negotiator, he may actually do more to help his beleaguered nation.  Despite the summer malaise, GDP for the second quarter was revised up to +3%, and corporate earnings have come in better than expected.  This is one of the most critical foundations for the market – the economy is growing and corporate profits are expanding.  Why not shrug off some “noise” when the basic underpinnings are solid?

The tragedies in Houston and Florida border on being biblical, and our thoughts go out to the many thousands of families who were displaced and will return home to find that everything that remains is water-logged.  Now the process of reconstruction will begin, and after a couple of quarters we would expect a positive impact on economic growth from the need to rebuild and replace.  AutoNation suggested that an additional 500,000 cars will be needed in Houston to replace those that were lost to the flood.  We remember how strong the L.A. economy was following the Northridge earthquake, and as cynical as it sounds, the disasters in Houston and to parts of Florida will actually bring about strong growth after a temporary set-back.

Data Points and Global Economic Indicators

If there is one area of concern for us it is to be found in the credit markets.  The 10-year yield, currently at 2.06%, is threatening to go below 2%, and that keeps us up at night.  Low interest rates historically are the precursor of economic contraction and/or systemic risks in the market.  At this point, there is no indication of either coming to fruition, but the low rates has us a little unnerved.   Why are interest rates going down if purchasing managers indices are rising and economic growth is healthy?

Why too is unemployment low while wage inflation is almost non-existent.  Here again, economic theory would suggest the opposite.

These inconsistencies give us pause for concern, and we remain cautious to the necessity of reducing equity exposure.  So far, we continue to come back to the basics that economic growth both here and abroad is strong, and corporate earnings are growing.  The probability of a recession seems quite low, and that helps us conclude that any market correction is unlikely to be the precursor to a more dire market decline.

Conclusion

For the moment, we are content to follow the tone of the market.  While we are somewhat more cautious due to the very low level of interest rates, we will try to ignore some of the bad news as long as the basics remain solid.  We do reserve the right to change our mind when the facts change.