Economic & Market Comments, Fall 2014

At KilterHowling we don’t spend time trying to predict the future; our clients know this. We don’t think anyone is very good at it, and it has not been a good use of time in our professional lives.

However, it is useful to periodically survey the state of the economy, the markets and the landscape that impacts our investment portfolios as much as our lives. October was a turbulent month for the investment markets, and some of history’s worst market moves, calamaties and ‘mini-crashes’ happened in October of: 1907, 1929, 1987, 1989, 1997, 2002, 2007. So, one would predict that the worst month for stocks is October, right? Wrong – September has consistently been, on average, the worst month for stock market returns. It’s just that October has seen some of the biggest calamaties.

Beware the temptation to forecast!

Election season is entertaining for all sorts of reasons – new commercials among them – but also, there is an overwhelming plethora of commentating on the state of the economy. Mostly it’s finger pointing, but we are feeling polite.

This is a longer, weekend-reader, style of blog post for us. We will review the state of things only periodically. We hope you enjoy it, and we welcome your feedback.

Financial Markets
Stocks: Year to date (“YTD”) markets have mostly risen, but not in a straight line. Coming off 30%+ returns in US markets last year, the S&P 500 has risen 10% this year, and 237% since the market bottom in March of 2009.  Small and mid-sized stocks have lagged, rising about 2% and 5.5%, respectively. International stocks in developed countries (Europe, Japan) have actually fallen around 5.5% as a group. Emerging markets (China, Brazil, etc) are mostly flat.

Bonds: In the U.S., for what feels like the umpteenth time, bonds have done very little. Interest rates continue to be very low. After last year’s meager -1.8% return in the U.S. bond market, the return year to date has been about 3%. Corporate bonds have returned about 4%. Junk bonds are down about 1%.


If one has the misfortune to tune into the financial news, you have likely been waiting for the apocalypse in bonds for several years now. I’ll let you in on a little secret: if you look back to 1950, the worst year in intermediate term government bonds (proxy for the market) is -4% in 1994. Last year was one of the worst ever… Don’t despair, all those canned goods will come in handy someday, but probably won’t be useful in the bond apocalypse.

I just have to explain this a little further – the chart below shows the interest rate on the U.S. government 10 year bond from 1953 to September 2014. In May of 1953 the rate was 2.37%. As I write this it is 2.36%. So, you wanna know what happens when rates rise? I’ll tell ya. Pretty much nothing. The worst annual return from 1953 to 1982 when rates hit 15% was -1.3% in 1958 (note: this data comes from the Ibbotson SBBI books available at your local library).

Emerging market bonds have been the darling of the bond world, and, predictably, the wall of money that has flowed there has tempered returns. YTD emerging market corporate bonds have risen about 3.6%, but in local currency terms returns are negative owing to a surging dollar. Just to be clear – the loathing in the bond market right now is so great that investors have, YTD, accepted the same return on emerging market corporate bonds as high quality U.S. corporate bonds. That strikes me as patently insane, or maybe I’m getting old. I am just old enough to have observed the Thai currency collapse and set off a market rout in…you guessed it: October 1997! Let’s not forget about those pesky defaults by the Russians in 1998, which blew up a hedge fund run by two Nobel laureates, and Argentinians on a regular basis.

Other Stuff: Gold has been a dud YTD, falling about 3% and commodities, mostly due to oil prices, have declined about 5% as a group. Oil in the U.S. has fallen more than 19% this year, to less than $80 per barrel (West Texas Crude, that is). This is incredibly good news for consumers and the economy. On the international markets oil prices have fallen more than 22% (Brent Crude). Wow! There are interesting geopolitical ramifications and chess moves behind this, and also serious implications for the U.S. shale and fracking booms. Legitimate concerns aside, the domestic fracking process has been a revolution and godsend for American jobs, and most of us who benefit from a rising economic tide have been positively impacted by this. But below $80 per barrel the issues will shift from whether we have a Keystone XL pipeline, to whether it is cost effective to pull oil out of the ground in places like North Dakota, Weld County, Colorado and West Texas at $78 a barrel. But for now, we can focus on the immediate impact of falling gas prices. If prices move from $4 to $3 then this puts about $50 a month into the pocket of the average American driver. This is good for the economy.

Inflation & Interest Rates

There is no inflation to speak of in the American economy. The long-term average over 30-50 year periods is between 3 and 4% per year. This is the problem with holding cash; money erodes at the rate of inflation. The fears of Central Bank policy intervention leading to higher inflation have been misplaced. At this point the Federal Reserve has executed and completed three specific, enormous, novel and untried Quantitative Easing (“QE”) programs. Across that entire time inflation was either below trend or even falling. We look at this a few ways: Core inflation is running about 1%. Wages tend to push inflation higher, and about the only labor market statistic that has not improved in recent years is average hourly earnings. Year over year they are flat – pretty much 0% growth. Finally, the velocity of money – how much the money in circulation actually moves around the economy – is at a 50+ year low. To a certain, and very important, extent it doesn’t matter one bit how much money the Fed prints if that money never circulates into the economy. And that is what we have seen.

So, no inflation, but why are interest rates so low? Well, interest rates, left to their own market forces, respond to inflation and economic growth. This is in turn tied to demand for borrowing money; a stronger economy has a lot of borrowers. The Fed through its QE programs artificially held interest rates low, but that all wrapped up last week. Why didn’t rates rocket higher? In fact, they have mostly fallen on every thing from government bonds to car and mortgage loans. Why? Because the current level of interest rates corresponds to the current state of the economic and inflationary environment. I’ve said it before writing on this topic: Money is cheap right now.

We run long-range financial plans for clients, and in the interest of being conservative and controlling for forecasting error we typically utilize a baseline 4.2% inflation rate – about the worst trend in U.S. history. We are happy to adjust this up or down for clients who have strong views. But for now, let us bask in this time of low inflation.

GDP and Consumers

For all the thrashing that I’ve heard recently about everyone being unhappy with the state of the economy, I’m pretty pleased. Unemployment is below 6%, continuing claims for unemployment insurance continue to fall steadily every month. The separations rate, a measure of how willing people are to quit their job, has risen 3% y-y. Consumer default rates continue to decline steadily as do consumer debt levels. Even before the plunge in gas prices, retail sales rose 3.3% y-y. We focus on the consumer because consumer spending makes up almost 70% of the U.S. economy.

U.S. GDP growth in real terms has been robust this year. While the first three months of the year we saw a decline, the second and third quarters saw 4.6% and 3.5% expansions, respectively. This is good, healthy, above trend GDP growth, and it’s  good news for small business owners and employees across the U.S. economy. As we are still the largest economy in the world and a net importer of goods, it is also good news for the rest of the world. The reign of Obama is coming to an end and, politics aside, it’s been a heckuva an economic recovery.

Valuation: Markets from Here

The most reliable way to forecast the future is to try to understand the present – John Naisbitt

We can only assess where we are now, consider where the markets and the world have been, and try to construct portfolios and planning scenarios that are flexible, adaptable and leave us and our clients with much optionality – that is, the ability to have many options.

The valuation of the U.S. stock market is above its long term trend, but certainly reasonable. It has been a very, very long time since the market had a significant correction or bear market. We are ‘overdue’ only in the sense that it’s been a long time since the last time. We do not think interest rates are worthy of our fear and loathing. The financial system is meaningfully more stable than it was 7 years ago; that is good news. We have just had some change in the leadership of the U.S. and more is on the way in 2016. Change is usually good, but can also be volatile.

The European and emerging market economic situations are not as rosy as the U.S. While we have just ended a period of extraordinary central bank accommodation, the European and emerging markets have generally reacted with more austerity, so their economic recoveries have been more bumpy and harder to predict. The exception is Japan, which has embarked on a quantitative easing program that dwarfs that of our Federal Reserve.  However, the European and emerging markets are much more attractively priced relative to their histories, but also more fraught with uncertainty for investors. Movements between these markets are very difficult to time. We intentionally have diversified our portfolios by investment style to attempt to correct for this. Some of our portfolio focuses on valuation while the rest ignores valuation and focuses on trends and momentum. The interplay of the two is optionality – we have the ability to adjust the portfolio, quickly, easily and at a very low cost.


As in political analysis, there are not many concrete answers in economic analysis, just mosaics of current facts both qualitative and quantitative. We feel good about the economy, a bit nervous about the bifurcation of U.S. markets’ ‘toppy’ nature versus attractive valuations but more obscured fundamentals in the rest of the world. We think the road in fixed income and bonds will be bumpy but manageable.

We spend many hours thinking about portfolio construction, risk management and also aligning our interests with those of our clients. We hope our portfolios, client communications, firm structure and results make this self-evident.