ECONOMIC/MARKET REPORT
ANALYTICAL CAPITAL
October 15 2018
Once again the market has shocked us out of our slumber. We are reminded that equity prices don’t move in one direction and, therefore, that returns are not achieved in a straight upward line. Investing entails risk; we only want to accept risk when we are rewarded accordingly. So, the question we must ask is the current risk environment acceptable vis-a-vis the expected reward?
Let’s carefully examine where we stood two years ago. Corporate profits were strong and interest rates were low (nonexistent, you might say). That’s a great environment for stocks because:
- future earnings are barely discounted;
- lower rates make it cheaper for businesses to expand, and higher profits make it worthwhile to do so;
- business spending – together with, at long last, invigorated consumers – raise aggregate demand, further contributing to corporate profits and the cycle, in a sense, feeds on itself.
Where are we now? Corporate profits remain healthy, but the support of historically low interest rates is gone. (The “trade war” with China isn’t helping, either.) Is it still worth the risk of being exposed to stock market volatility?
Here’s a sobering but, at the same time, positive thought: Interest rates near zero are not the sign of a healthy economy. A country growing near its potential (and so estimated by the Federal Reserve for the U.S.) should have nominal and real (net of inflation) interest rates noticeably above zero, and should be able to tolerate it (and allow savers to enjoy it!). Is that the case for the United States today? We can’t be sure, but we’ll give it the benefit of the doubt. Why? Because, all things considered, historically we are still paid to take long-run risk in the equity market, especially in the healthiest economy on the planet, and future returns seem no worse than average.
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The changing economic/market landscape, as described above, calls for significant shifts in investment strategy. Clients will see, over time, increased allocations to fixed income, now that interest rates have come up. There will also be shifts between sectors within the equity portions of client portfolios, with the emphasis on cyclicals somewhat reduced. We will also be examining alternatives – international investing, for example – for opportunities that are attractive in the current environment.
