Markets were relatively quiet during August, with trading volumes quite low and stock prices little changed for the month. Central banks were in the headlines, as the Bank of England took new stimulative measures and Janet Yellen indicated that the Fed may be nearing its next rate hike. We continue to have a somewhat guarded outlook. While the fundamental picture remains relatively stable, we question whether investors may be a bit too complacent, as evidenced by very low levels of equity volatility and stocks close to all-time highs.
The Bank of England (BOE) took historic measures in August by cutting its benchmark interest rate to a record low level of 0.25%. It also revived a program to buy UK government bonds, and announced new discounted 4-year loans for banks in an attempt to spur lending to businesses and households. The central bank also suggested that another cut could be imminent, which would take interest rates down to 0%. While it is not surprising that the BOE acted in the wake of ‘Brexit’, what has been more unexpected is the resiliency of the UK economy. Thus far there has been little evidence of a widely expected recession following the country’s vote to exit the European Union. In fact, the manufacturing and retail sectors of the economy appear to be holding up relatively well, and the significant drop in the pound has been a boon for tourism. This is an encouraging development, and while early, it may be an indication that the consequences of ‘Brexit’ might not be as dire as many had feared.
In the U.S., investor attention was drawn to Jackson Hole, Wyoming, where the Federal Reserve held its annual economic policy symposium. Fed Chair Janet Yellen was one of many speakers on the docket. In our view, her remarks suggested growing confidence on the Fed’s part that their next interest rate hike would likely occur in the coming months. She noted a solid labor market and the central bank’s forecast for a pickup in economic growth as factors supporting a higher interest rate target. While the market appears to have been preoccupied with the timing of the next rate hike, our key takeaway from Yellen’s comments was the great uncertainty with regards to where rates will settle over the longer term. By the end of next year, she alluded to a potential range of 0%-3.25% for the federal funds rate. Moreover, despite the substantial magnitude of this range, based on past forecasting errors there is nearly a 1 in 3 chance of rates actually landing outside of this span. Put another way, we believe great uncertainty remains with regards to the interest rate outlook, and while the Fed has often noted that it is data dependent, we think this is perhaps even more true today than in the past.
We are keeping a close eye on increasing labor costs and are considering the implications of this dynamic on our investment holdings. While wages decelerated in August to 2.4% on a year over year basis, July’s 2.7% gain was the fastest in seven years. As well, unit labor costs grew by 4.3% during the second quarter. With productivity flagging, wage increases could pose problems for corporate margins. Certain sectors are more sensitive to labor costs than others, and we expect that this distinction will be of increasing importance as the current economic expansion continues to mature.
We maintain our cautious stance on the market. In our view, the near-term economic picture remains uncertain. In recent months we have seen a divergence between the labor market and overall economic growth. The former has been relatively healthy while the latter has been sputtering along at a below trend GDP growth rate of approximately 1% in recent quarters. We doubt whether this discrepancy is sustainable, but which factor normalizes and to what extent remains an open question. Economic bulls would point to positive consumption data along with encouraging durable goods orders and industrial production metrics. Moreover, the Atlanta Fed’s real time GDP projection is calling for a meaningful acceleration in growth to over 3% for the current quarter. With that being said, capital investment has been a drag on growth, and we question whether it will meaningfully improve over the near-term, particularly with election related political uncertainty impacting corporate level decision making. While we are not overly negative on the fundamental landscape, we think there are sufficient economic and political uncertainties to question whether stocks should be approaching all-time highs and carrying elevated valuation multiples.
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