If Inflation Is Fizzling Out, Can Profits Be Far Behind?

For decades, experts at the US Federal Reserve, academic economists and portfolio managers have been at war with inflation — the phenomenon of price increases without commensurate productivity gains. Investors and policymakers alike hate inflation because it robs consumers of buying power and discourages money flows into long-term investments for fear that their value will be eroded. The remedy for inflation in past cycles has been for central banks to raise interest rates in order to cool off growth and end speculative investing, thus curbing broad-based consumer price increases. Usually inflation flare-ups occur a couple of years into a cycle, or at mid-cycle at the latest.

This time, the cycle is getting old — very old — but inflation remains surprisingly tame, running well behind previous US cycles. Meanwhile, similar patterns are playing out globally. Chinese inflation is slowing. The eurozone, despite growth that has exceeded expectations, has seen disappointing inflation data of late. Japan is a similar story. Even the UK— which has seen a post-Brexit-vote inflation spike on the back of a weak pound — has witnessed a downtick in prices, according to recent data.

Pricing power and inflation linked

Inflation is inextricably linked to companies’ pricing power. And in the late stages of a cycle, it is usually the ability to raise prices that drives revenues up against a base of fixed costs, expanding profit margins. But inflation remains well contained in much of the developed world, limiting companies’ ability to raise prices.

This time around, the lack of inflation may mean trouble for a market that is more expensive than 90% of previous market periods. As the old saying goes, it is priced for perfection. But already we’ve seen that June US retail sales have disappointed, that car sales and prices are weak and that apartment rents have started to flatten out. This lack of pricing power could negatively impact future sales growth, and could become an increasing discomfort for a market that has known only quarter after quarter of rising stock prices.

Global Equity

One of two problems

In my view, the market faces one of two problems going forward:

  1. Historically, inflation and corporate borrowing rise during the late stages of a business cycle. This levers up returns to shareholders — for a while. But at some point, usually before the economic data roll over, the market loses upward momentum and share prices fall because of a deadly combination of tighter monetary policy, decreased investment and flagging profits. If companies lever up, the cycle typically follows its normal course toward decay and recession, since companies usually increase leverage at precisely the wrong time. And history tells us that risky assets like stocks and high-yield corporate bonds tend to fare very poorly during economic downturns. In fact, the typical decline in the S&P 500 Index during a recession is 26%. That’s a serious hit to anyone’s nest egg.
  2. However, this cycle looks atypical, given the lack of late-cycle inflation pressures. So if subdued inflation continues to retard pricing power and profit growth, then most companies likely won’t live up to earnings expectations, and stock prices could suffer as a result.

Miracle solution?

Is there a solution to the above two problems? Perhaps inflation comes back, pricing power returns and central banks don’t choke off the moderate global economic expansion now underway. But that’s an outcome I’ve not witnessed during my entire career. Alternatively, we could assume that things really have changed and that the business cycle can extend indefinitely. Or that the US Congress will cut taxes enough to spur a resurgence in economic growth.

However, I’m not buying the notion that business cycles are a thing of the past. Nor am I buying that politicians can make much of a difference. Since I’m not expecting any miracles, I’d rather focus on preserving the huge market gains — on the order of 300% — made since the market low in 2009.

For investors and business cycles, age matters

For investors, age is essential in determining how much risk one can assume. For business cycles, one can say the same. The average business cycle lasts five years, and the cycle we are in today is eight years old. The longest cycle on record is 10 years, so history suggests we’re getting late in the game. The later we get, the more the risks of the cycle coming to an end rise. This is especially important given the aging of the global population. Investors, on average, need to take less risk today than they did a decade ago, and should be particularly mindful of the potential for the cycle to end at any time.

Against a backdrop of aging global demographics, slow economic growth and record-high debt levels, investors would be wise to exercise caution rather than taking risks at this late stage of the business cycle.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

 

Past performance is no guarantee of future results.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

Don’t Fear the Commodity Slump—Yet

Aerial photo of the front end of a large fully loaded container ship.

So far it has been a great year—at least for paper assets. Long-dated U.S. Treasuries are up 4%, high yield 6%, the S&P 500 nearly 10% and emerging market equities over 17% in U.S. dollar terms. But it has been a less inspiring year for commodities.

Some investors are wondering whether softer commodity prices represent a sign of economic deceleration—along with a flatter yield curve and decelerating inflation—or an even bigger threat. For now, I think the answer is no. Here are three reasons why:

Commodities prices have witnessed significant divergence

Not all commodities have done poorly year-to-date. The weakness in some commodity indexes has been largely about energy. Oil prices are down nearly 20%; natural gas has done even worse. However, metals have performed better along with select agricultural commodities, notably corn and wheat.

2017 Asset Performance

The drop in energy has been as much about supply as demand

It is true that oil demand has slipped: The International Energy Agency (IEA) puts worldwide crude demand in the first quarter at 96.45 million barrels per day (bpd), down from over 97.60 million bpd at the end of 2016. However, compounding the problem has been a rebound in supply. Two OPEC countries in particular have surprised with higher production: Libya and Nigeria. Libyan production has quadrupled from last fall’s low, while Nigerian production has risen by more than 300,000 bpd since last August. At the same time, U.S. shale producers continue to demonstrate remarkable resiliency in the face of lower prices. U.S. domestic crude oil production has climbed by almost 600,000 bpd since late December and by nearly one million bpd from last fall’s lows.

Cyclical commodities are doing well on the manufacturing rebound

While precious metals are having a mixed year—gold up, silver down, platinum flat—industrial metals have generally been strong. The Journal of Commerce (JOC) Industrial Metals Index is up approximately 6% year-to-date. This is consistent with the global improvement in manufacturing surveys. For example, in the U.S. the Institute for Supply Management (ISM) Manufacturing Index has risen three points since December and is now close to a three-year high. Even more encouraging, the new orders component has been particularly strong. This is important as the level of new orders correlates closely with industrial metal gains. To the extent manufacturing surveys—and particularly new orders—remain high, industrial commodities are more likely to be supported.

For now investors can look past softness in commodity indexes. What would change my mind? Two things in particular would cause me to worry: a sharp downturn in leading economic indicators or substantially tighter financial conditions. For now, the former is not visible. On the latter, while the Federal Reserve is tightening and the European Central Bank is musing about less accommodation, financial conditions remain easy thanks to still low interest rates, a weak dollar and tight credit spreads. Should these conditions remain in place, investors can, for now, look past the challenges in the commodity sector.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

July 2017 Investment Newsletter

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With summer now officially upon us it seems like the excitement that many of us have witnessed in schoolchildren who are newly on summer break has carried over into the markets.  The S&P 500 rose an additional 2.6% in the last three months bringing this year’s total growth to roughly 8.2%.  The long-term bull market we have been in (the second longest on record) has many investors concerned about how much longer the bull market can continue.  At its most fundamental level the equity markets are driven by the economy and corporate earnings.  Which brings us to the key question: will the current economic environment support continued growth into the future?

Our research indicates that it does…for now.  No one holds a crystal ball that allows them to perfectly predict the future.  However, based on our broad analysis of corporate earnings reports and key economic indicators ranging from inflation, economic leading indicators and productivity we do not see a near-term recession on the horizon.  As a result, while we recognize that we are now in a late stage of the market cycle, we do not expect to see a large-scale correction in the near-term.

With this in mind, however, there are some key characteristics of the current market environment that we believe are worth noting as intelligent investors:

  • US Stock Market Valuation: If we look at the US stock market from where we have been using the trailing 12 months price-to-earnings ratio for the S&P500, it is currently at roughly 23.8x versus the historical mean of 15.7x. Looking forward using the projected earnings of the S&P500 we get a price to earnings ratio of 18.7x, much closer to the historical mean. This implies that corporate earnings will grow at a faster rate than stock prices over the next 12 months.  In a market like this it is important to find value investments with low PE ratios that are growing earnings and/or growth investments that have accelerating earnings.
  • European Opportunity: The international markets, which have largely trailed the US post-recession recovery, are beginning to show signs of life.  Europe, in particular, looks promising to us.  For example, in the first quarter of this year the earnings of Europe’s largest companies grew by 9% more than those of comparable US companies.1 Additionally, the European Union, under the implicit leadership of German Chancellor Angela Merkel, seems to have found newfound commitment to one-another, which is important since Germany will need to continue financially supporting its southern neighbors to keep the EU together.

Some investors have remnant concerns about the effect that Britain’s exit from the Union (“Brexit”) will have on the region. While we acknowledge the difficulty of the situation, we believe that both sides will engage in significant political posturing to appear strong to their respective constituents but will ultimately make a deal behind the scenes that is acceptable, although not enjoyable for either side.  Britain is the EU’s second largest trading partner after the US and consequently neither side will prosper if too many barriers to trade are created. We would also note with some humorous solace that July 4th represented our own “1776 Brexit.”

  • Financials: Financial stocks, particularly bank stocks, have underperformed relative to many of the other sectors for most of the past quarter. We believe there will be a reversion to the mean in terms of performance as many of these investments look inexpensive compared to other sectors.  While the lack of robust inflation and the delay in congressional actions have softened investors’ appetite for banks we do not believe that will last in the long-term.  Despite legislative delay we still believe that before the 2018 mid-term election we will see some tax reform along with continued deregulation of the banks which will help boost earnings and thus share prices.  The largest US banks also have significant international operations and will benefit from global growth, especially in Europe.
  • Floating Rate Investments: As long as the US economy continues to grow the Federal Reserve will likely continue to increase interest rates slowly over time. Since many investors diversify a portion of their holdings into bonds they may find it useful to put a percentage of that allocation into bonds or bond vehicles that adjust upwards with inflation (“floating rate”).

While the above bullets focus on four investment themes that we believe are relevant at this time, they do not cover all of the many variables that our investment committee looks at each quarter.  As a result, if you have any questions please do not hesitate to reach out.

I hope you have a wonderful and fun-filled summer,

Susan McGlory Michel

 

Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.

Putting Risk on a Budget

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Investment risk is one of those things that’s not very easy to describe—no less budget for. This may well be keeping investors from making the most productive use of their assets.

Indeed, findings from BlackRock’s Global Investor Pulse survey reveal that one-third of advised U.S. respondents feel certain they would invest more if they had a better understanding of the risk levels in their portfolios. Another third would possibly invest more with a better understanding of these risks.

Our work with financial advisors reveals that defining and keeping risk on a budget isn’t easy. We generally see two different approaches to portfolio construction aimed at improving the experience of the markets: 1) Achieve a return similar to your benchmark but with less total risk, or 2) generate a higher return than the benchmark, but at the same risk level. Of the first set, only 35% of the portfolios we surveyed met the stated risk goal; in the second set, 53% met their risk target.

Risk Budgeting

Investors are not intentionally building portfolios that miss their risk benchmarks. Many of the products used in building portfolios today have simply become more volatile than the market itself.

Consider that, 10 and 20 years ago, less than half of broad equity funds were riskier than the S&P 500 Index of large-cap U.S. stocks, according to data from Morningstar. Today, the number is 75%—markedly higher than the historical precedent.

Rationalizing risk

What’s an investor to do in this environment? We recommend keeping a few things in mind as you seek to understand and budget risk:

Keep it real

The framing of risk can make all the difference. Consider that a $100,000 investment in an asset with an annualized level of volatility of 10% could easily undergo a drawdown of $10,000 in any given year. The question isn’t whether 10% volatility feels OK to you. It’s: “Can I bear a loss of $10,000 in value at any moment in time?” If the answer is no, you likely need to consider more conservative options or balancing that asset with a less volatile investment.

Diversify risks, not just asset classes

Just because we call a security a stock or a bond doesn’t mean it will always act like one. Case in point: High-yielding stocks can sometimes serve as bond proxies, and lose value when rates rise. It’s important to look beyond the labels to understand the risk drivers behind each asset you’re choosing. The goal, for example, is to understand the amount of equity risk you have—not simply the amount of equities you own. Only then can you truly diversify your portfolio.

Don’t assume recent history will repeat

Measuring the risk associated with past returns will not always paint a complete and accurate picture. The S&P 500 Index has demonstrated annual volatility below 11% in four of the past five years. The historical norm observed over the prior four decades was 15%. So which is right? There are no crystal balls in investing, but working with an experienced advisor and an investment manager with expertise in the strategy you’re pursuing can bestow valuable perspective.

Know the risks you’re taking

And the more risks you understand, the better. BlackRock has identified over 2,200 unique risk factors, and has a powerful system to measure any given portfolio’s sensitivities to different types of stress scenarios. Our risk-management technology analyzes the ongoing relationships between millions of tradable securities around the globe, giving our investors access to a vast amount of risk intelligence.

Contemplating risk on these dimensions can help ensure the risks you’re taking are deliberate, diversified and appropriately scaled. And putting your portfolio on a risk budget can not only help you stay away from danger zones along the journey toward your long-term investing goals, but can also help you to better navigate the emotions that go along with investing—no matter how you define “risk.”

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Into Thin Air

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Despite growing political risk and high valuations, the stock market—like the Energizer Bunny—keeps going and going, grinding upward. I believe that markets can still move higher, and there are good reasons for the ongoing rally—namely, strengthening global growth, and stronger widespread earnings. Still, most traditional valuation ratios indicate that stocks are expensive (particularly in the U.S.) and future returns are likely to be muted.

So where does that leave us going forward? History does provide some interesting insights about how markets perform in the periods when U.S. stocks are expensive—and how investors can think about ways to position their portfolios.

To begin, how expensive are stocks in the U.S.? The current Shiller cyclically adjusted price to earnings (P/E) ratio of the S&P 500 is over 29, well above its long-term average of around 17. But to put that number in perspective, the same measure was in the 40s during the dotcom bubble and has exceeded 30 less than 4% of its entire history going back to 1881. Other valuation metrics tell a similar story: Stocks are expensive, although it is not clear that they are yet in bubble territory. The lights are arguably flashing yellow, but certainly not red. It is also worth remembering that value is a poor short-term indicator of market performance.

Still, historically, when valuations have been at these levels, performance in the next few years has been significantly lower. When the cyclically adjusted P/E of the S&P 500 has been greater than 28, average annual returns over the next three years has only been 0.7%. In short, while the outlook for U.S. stocks is hardly bleak, investors should expect significantly lower returns over the next few years than what they have become accustomed to in recent years.

Having said that, there are areas of the market that have outperformed the S&P 500 in relatively expensive markets. Minimum volatility strategies, particularly dividend growers, and broader world allocation strategies all outperform the S&P 500 in periods when the cyclically adjusted P/E ratio exceeds 28.

High Valuation Performance

Since the end of the financial crisis and the beginning of the current bull market, the market environment has been unique. Significant easing by global central banks, historically low yields, sluggish economic growth, demographic factors—all have resulted in a market environment unlikely any seen in decades (if ever).

In short, no one can be sure how various asset classes will perform, if or when the current bull market loses steam. But it is unlikely the broader S&P 500 will continue to be the workhorse it has been in the recent past, and being more selective will be key going forward.

For example, strategies that look for growth with a broader mandate and that thoughtfully manage risk will play an important role. This is for several reasons: First, such strategies can build portfolios from the bottom up and therefore be very granular when gaining exposure to various markets (and avoid the more egregiously overvalued parts of the market.)

In addition, these strategies can shift between regions. Today, for example, emerging markets, Europe and Japan all look more reasonably priced than the U.S. All of these factors suggest a more effective approach toward navigating the current period of high valuations.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.