Ensemble Capital Client Call Transcript: Market & Economic Comments
We recently hosted our quarterly client conference call. You can read a full transcript here. Below is an excerpt from the call discussing our current views on financial markets and the economy.
Excerpt (Sean Stannard-Stockton speaking):
For the last two quarterly conference calls, which bracketed the presidential election, we’ve commented extensively on the intersection of politics, the economy and financial markets. Our message has been that while investors need to recognize the ways that public policy can impact the business prospects of individual companies, there is little evidence of any reliable way to predict how politics will impact the stock market. Indeed, investors have been best served historically by ignoring politics. Letting politics sway your investing can be harmful to your financial health.
So while the mainstream and financial news media are covering politics around the clock, we’d argue that the most important drivers of financial markets this past quarter have been basic economic trends.
The fact is, the US economy continues to improve. Almost a quarter million jobs were added to the US economy in both January and February and the three month moving average for the first quarter was in line with the job creation levels we’ve seen throughout the recovery. Importantly, over the last year people have been coming back into the workforce and the percentage of Americans who are employed or actively seeking employment has started to rise. While this metric fluctuates, the 12-month average participation rate is now increasing after being in continual decline since 2008. Today, there are 8 million more jobs in America than there were just prior to the financial crisis.
Unemployment claims are exploring new lows this week. The number of people who reported filing for unemployment benefits this past week registered at the lowest level of the recovery and indeed is the smallest number of people to file for unemployment in any week since the early 1970’s when the US workforce was literally half the size it is today. As a percentage of the workforce, there has never been a time when so few people have been reporting the loss of a job. And in addition to new jobs, wages have been growing recently at the fastest rate since the end of the financial crisis.
Interest rates are moving up. The 10-year treasury yield averaged 2.4% in the first quarter. While this is still well below the long term average, it is the highest average quarterly yield in over two years. The last time we saw as big of a move up in interest rates was in 2013 when the stock market raced higher by 32%.
But higher interest rates seem like a bad thing to most people. So why have rising interest rates generally been associated with a strong stock market since the Financial Recession?
Over the longer term, the yield on the 10-year treasury bond has tended to approximate the rate of growth of the economy. So while low rates might spur borrowing to finance investments and large consumer purchases, if the economy is indeed going to eventually return to the rates of growth we were accustomed to for the 50 years prior to the financial crisis, interest rates should move higher. While the bond market is not that great at predicating the future, its behavior is supportive of the idea that the economy is improving.
In general, the stock market has rallied during period of low rates increasing back towards average levels as the economy recovers from weak growth. While the stock market generally does poorly when interest rates increase to above average levels at the tail end of a robust economic boom. So for the time being, we would expect ongoing increases in long term interest rates to coincide with solid stock market performance, as it has recently.
Inflation has also been picking up. Like with rising interest rates, most people perceive rising inflation as a bad thing. But economists generally believe that a low, but positive rate of inflation is good for the economy. Historically, market PE ratios have been highest when the rate of inflation is between 2%-3%. This is in fact where inflation expectations were during much of the initial market rally from the great recession lows during the 2010 to 2014 time frame. But starting in 2015, inflation expectations began to decline, falling as low as 1.2% as the market bottomed last year.
But since mid last year, inflation expectations have been increasing in a positive sign for economic growth. As we moved into the first quarter, inflation expectations once against moved back into the 2%-3% sweet spot for market performance.
One more counter-intuitive sign of the improving economy has been the increase in oil prices. The price of oil traded above $50 for much of the first quarter, the first time it has traded that high since mid-2015. A stronger economy demands more energy and while too high oil prices, too high inflation and too high interest rates can all crimp a robust economy, when they occur in the context of an economic recovery they are signs of economic strength.
So when we take a step back, what begins to emerge is a picture of an economy that recovered at a slower than average pace from 2010 to 2014. Then during 2015 and the first half of 2016, economic conditions seemed to deteriorate, with worries about a potential recession triggering the 15% correction in the stock market from December 2015 through February 2016. Since then, economic conditions have been improving again and the stock market has responded in kind.
Now don’t for a minute think any of this tells us what is going to happen next. These observations about the economy and market offer context for where we’ve been. Too many investors fret that the recent market rally is related strictly to possibly misplaced hopes about lower taxes and regulations coming out of Washington. But they are missing the fact that while politics has dominated the news cycle for the last year, the US economy has been in the midst of posting steady improvement.
You can read the full transcript here.
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