“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.” — Mark Twain
Second Quarter Highlights
During the spring, both the economy and the markets continued their slow grind upward, confounding investors flush with cash. Equities appreciated, even as the Trump agenda of lower taxes and infrastructure spending stalled in Congress. Earnings surprised with double digit gains, revenues rising for the first time in three years. Bonds rallied alongside stocks at first, but later decoupled, as central banks in the Eurozone, the UK and Canada signaled that either higher interest rates or less monetary stimulus were on the horizon. For the first time in several years, it appears that many central banks, especially those in developed nations, are trying to pursue similar policies.
Current global central bank policy reflects the first global synchronous upswing in economic growth since 2010, with China and the Eurozone recovering and emerging economies such as India contributing to global growth. Increasingly, it appears that the cause of the market rally since last fall’s election has been due to excessive pessimism in the face of gradually improving economic growth rather than the realization of the more salient points of the Trump agenda.
A Lot of Activity Beneath the Surface
There was a wide disparity in sector performance, with leadership changing late in the quarter. The Information Technology sector initially led the market, as investors sought companies possessing their growth characteristics. Later, other growth stocks such as Healthcare followed. In June, with rates rising and favorable results from the Federal Reserve’s “stress tests”, value stocks such as Financials rallied.
The rising tide did not pick up all boats, however. The Energy sector continued to fall, with OPEC’s production cuts failing to stem the oversupply of oil due to the ramping up of production among U. S. fracking companies. Many retailers and other Consumer Discretionary companies plummeted, feeling the effects of overexpansion along with the disruptive aspects of ecommerce companies such as Amazon.
Changes were happening in the geopolitical scene as well. The ascension of Saudi Crown Prince Mohammed bin Salman signaled a more aggressive foreign policy, especially with respect to archrival Iran and its allies, while moving closer to the US. On the economic front, MbS (as he is widely known) is seeking to diversify the kingdom away from petroleum and planning the partial sale of Aramco, the Saudi oil giant, as a first step in that direction. Social changes may also gradually occur, with the 31-year-old heir acknowledging the young population by suppressing the country’s religious police. Other reforms, including some concessions to women, may be introduced. This heralds an eventual change in the entire Middle East region.
In other parts of the world, North Korea’s recent test of an intercontinental ballistic missile will likely change the geopolitical paradigm in East Asia, with China and Japan as major participants.
The Fed is still indicating one more interest rate hike this year, possibly in September. Afterwards, it will probably pause and begin to shrink its massive balance sheet. It will be interesting to see if upcoming economic reports confirm the US central bank’s forecasts, and if enacted, what will happen to the shape of the yield curve when the balance sheet shrinking commences.
A noteworthy point is that most of financial deregulation does not require Congressional approval and the Administration is proceeding rapidly in that regard. Besides helping the banks, it may also increase lending and could finally cause an increase in “velocity” — an economic term referring to the rate money changes hands in the economy within a given period. The anemic pace of velocity for the past several years has been cited by many economists as a major reason for the slow recovery thus far.
Locally, Hawaii’s economy continues to be helped by tourism, which is showing its sixth consecutive year of growth both in arrivals and spending. Construction also remains strong, with both residential and commercial permits increasing nicely. The mid-Pacific hurricane season may be slightly more active than normal this year, though hopefully, the islands will be spared any direct hits.
We remain constructive on equities, although recognizing that a correction can occur at any time, especially after the rally in prices that has happened so far this year. Valuations are not cheap, but earnings and revenues are finally rising again and should continue for the next few quarters.
The economy is still growing at a moderate pace and does not show the excesses that normally appear prior to recessions. It will be aided by a Federal Reserve that will tighten monetary policy only gradually. We still believe that bond yields will rise in both the short and long term maturities, causing the yield curve to steepen. Global financial markets should mirror the US, with improving economies worldwide aiding stocks while causing low bond yields to rise.