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LBW Commentary Q2 2018


How LBW Sees It

Last quarter we made an analogy about how my (Tim) favorite roller coaster growing up closely related to the markets’ Q1 volatility. Q2[1] wasn’t as bumpy regarding price fluctuation - the S&P 500 TR ended up 3.43%[2], the Dow Jones Industrial Average TR was up 1.26%[3], and the MSCI ACWI Ex USA Index was down -2.39%[4]. However, headlines, of course, did not disappoint. The Trump administration is amid a possible trade war across the globe, the economy has continued to show its newly-revived strength, the Federal Reserve (“the Fed”) is continuing its path to raising the federal funds rate, and the yield curve[5] is flattening to the point of potential inversion.

Trade Wars

As many of our readers most likely know, the U.S. is currently feuding about trade agreements with countries across the globe. Thus far, the Trump administration’s main target has been China. In the past few months both countries have imposed different tariffs which, depending on the expert, could be a bad or good thing for the economy. However, the actual effect on both countries and the world, is truly unknown. The unknown and inconsistency in talks doesn’t sit well with the markets, thus creating volatility in the short run. Our take – we are unsure how this will pan out and to accurately project the effects on the U.S.’ and world’s economies is almost impossible. Even taking a historical point of view to assess the potential impact is almost useless as the world has never experienced globalization on this level. All we really know, is some things will change and the uncertainty will drive markets to potential irrationality.

Q2 Economic Data

The economy has been on an upward trajectory for the past few years. Inflation and interest rates are on a steady incline, and in recent quarters, wage growth has experienced a moderate up-tick. For example, the Fed stated that inflation is nearing their 2% objective over the medium term, supporting data suggests above-trend GDP growth, the unemployment rate fell to 3.8%[6] in May, and data indicated moderate growth in hourly earnings[7]. Simply put, the data indicates that the U.S. economy is continuing its gradual ascent from the Great Recession. It’s great to see stability in the U.S. economy, it means people and businesses are doing well. However, with every up there is a down; that is how economies work. The difficult question to answer is “When will it turn?” because no one knows. What if the trade wars get so out of control it throws the economy into a recession? Or, what if the Fed’s winding down of quantitative easing is too fast? There are so many variables to the economy it is hard to accurately predict its future. This is why we have a long-term investment horizon, focus on things we understand, and build in a margin of safety.

The Fed continues to increase the federal funds rate

In the Fed’s June meeting the Committee decided to continue their gradual approach to policy firming and increased the federal funds rate target by 25 basis points, moving it to a range of 1.75% – 2.00%[8]. In addition, most participants felt the data warranted the equivalent of either three or four increases of 25 basis points each to the federal funds rate’s target range over 2018[9]. With that said, the Committee also felt future guidance is no longer pertinent as the state of the economy moving forward is unknown and changing their guidance may be warranted in the near term. As stated above, the U.S. economic data is supportive of the Committee’s decision to continue tightening. Once again, this is good; however, it also indicates we may be approaching an economic cycle peak. Adding to the difficulty of assessing where the U.S. truly is in the cycle is that the U.S., and the rest of the world for that matter, has never experienced the quantitative easing measures implemented over the past decade. So, to know if it was right or wrong is almost impossible to know. The only thing we do know, is that time will be the final judge.

A flattening yield curve

There have been recent headlines surrounding the flattening of the yield curve. For those who are unfamiliar with what the yield curve means, below is a brief description:

“A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is also used to predict changes in economic output and growth.” [10]

Typically, an investor wants to see a “normal yield curve” in which you have an upward slopping line. This typically indicates the economy in an expansionary mode. The curve becomes upward sloping because investors will pile into short-term bonds assuming yields on long maturity bonds will increase and they do not want to lock in their capital at lower rates. Based on the U.S. economic data and the Fed’s outlook, one would assume we should begin to see more of a normalized yield curve, but we’re not. If the yield curve continues to flatten and becomes inverted, it may indicate a recession is ahead. An inverted yield curve means investors are buying up longer maturity bonds as they feel long-term interest rates will not increase. The yield curve is only an indicator, but it is something to pay attention to.

The headlines presented are mixed, the economy seems to be stabilizing, but at the same time it looks as if the U.S. is hitting the peak of its roughly decade-long expansion. Throw in potential political risk and uncertainty begins to be the dominate sentiment. The macro picture remains the same: extremely difficult to accurately predict. The potential trade war is a great example. Depending on the tariffs that stick, it could positively or negatively effect certain industries in a real way. With that said, we always take macro factors into consideration; they do not, however, dictate how we invest. As we move along, we will keep an eye on prices, if they dip to levels of a sufficient margin of safety, we will be there to take advantage.

Nathaniel's Beautiful Mind

I did a presentation at Manual of Ideas (MOI) in June on Formula One Group (FWONA/B/K), a tracker stock of Liberty Media Corporation. So, for this quarter’s “Nathaniel’s Beautiful Mind” I present you with a link to an audio file that you can download to have some easy-listening material while commuting to work. We hope you enjoy and any comments are most welcome.

https://moiglobal.com/nathaniel-leach-201806/

Sincerely,

LBW

[1] 4/1/2018 – 6/30/2018

[2] LBW Wealth Management, sourced from: http://us.spindices.com/indices/equity/sp-500

[3] LBW Wealth Management, sourced from: https://us.spindices.com/indices/equity/dow-jones-industrial-average

[4] LBW Wealth Management, sourced from: https://www.msci.com/documents/10199/ca7b1b93-7bae-4fe2-928e-7340ff17c71c

[5] https://www.investopedia.com/terms/y/yieldcurve.asp

[6] The unemployment number involves several factors. For example, people who have been unemployed for a certain amount of time, have ceased receiving benefits, and have not looked for a new job will be removed from the labor force numbers. Meaning, there may be more to the unemployment rate than initially meets the eye.

[7] https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180613.pdf

[8] https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180613.pdf

[9] https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180613.pdf

[10] https://www.investopedia.com/terms/y/yieldcurve.asp

#quarterlycommentary #tradewar #federalfundsrate #yieldcurve #Formulaonefroup #FWONABK

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