Freedom Returns

The United States of America celebrates 241 years of freedom. US investors and policy makers celebrate eight consecutive years of economic expansion. We should not expect the longest expansion recorded in US history to die only because of old age. Still, many developing events are requiring investors to continually update their forecasts. 

The Federal Reserve banking system was especially active in June. Policymakers of the regulatory body voted to raise the overnight rates that banks charge one another for excess reserves. Floating interest rates in the three-month LIBOR market, a market systemically important to international banking and linked to many consumer and business loans, responded by rising 0.1%.

The Fed’s interest rate decision was highly anticipated, although the Fed’s hawkishness is beginning to startle investors. Some think that the Fed is moving too quickly. Annual inflation remains below the Fed’s target of 2% despite the economy operating at full employment. The unemployment rate now resides near 4.8%. This puzzles some economists who are believers in the Phillips Curve. The Phillips Curve argues that inflation should be rising when unemployment is low. 

The disconnect between inflation and unemployment is also providing some uncertainty in pricing long-term Treasury bonds. Sluggish inflation expectations sent 10-year interest rates on US government bonds as low as 2.14%, but this rate has since recovered to 2.30%.
The rise of short-term interest rates and the downward pressure on long-term interest rates is forcing the yield curve to flatten out. A flattening yield curve is contradictory to economic expansion and bad for the business of banking. Banks make their profits by mismatching the maturity of assets and liabilities. Banks will borrow short and lend long, thereby earning an interest rate spread. Year-to-date, US financial stocks have been laggards, but shareholders of financials finally received some good news. The Fed recently wrapped up its evaluation of the ability of US banks to sustain losses in another financial crisis. The Fed found that banks were well-capitalized and cleared them for raising dividends and share buybacks. Financial stocks bounced in late June on the announcement.
 

“THE RISE OF SHORT-TERM INTEREST RATES AND THE DOWNWARD PRESSURE ON LONG-TERM INTEREST RATES IS FORCING THE YIELD CURVE TO FLATTEN OUT.”
 

Undoubtedly, the key for future financial prosperity must come from the vitality of bank lending and the ability of corporate earnings to capture an ever-increasing share of gross domestic income. The volume of bank loans was on a linear uptrend since the throes of the last recession, but the trend has recently plateaued. Fortunately, corporate profits as percentage of the nation’s gross income are at historic highs. The economy could benefit from more bank loans. Unfortunately, the unflattering yield curve posture may keep banks on the defensive. 
US elected representatives really have an opportunity to send a positive message to the markets. Sadly, lawmakers are proving to be ineffectual at passing meaningful healthcare legislation that will work for Americans. Partisan politics are increasing the odds that material policy for infrastructure spending and tax reform are unattainable. Another overhang on governments are the promises made to state and local employees. State and local governments can cover only about 70-to-80 cents of each dollar owed to current and future retirees. American corporations have this problem, too. About 15% of their liabilities remain unfunded. The shortfall in government coffers puts active public employees, pensioners, and creditors at risk. Governments may be forced to raise taxes to mend their budgets no matter the political costs. Indeed, news of rising taxes around the country will damper the euphoric optimism held after last year’s election. 

Now, investors ramp up for the second quarter earnings season and a read on the nation’s economic progress. Analysts are forecasting higher corporate earnings and the Atlanta Fed’s prediction is 3% annualized growth from the second quarter. Investors can probably expect market trends to continue should actual figures match or exceed forecasts.

 

MARKET MOVERS

US equity exposure was the best performing category in June. Meanwhile, foreign equity performance closed the month relatively flat. The recent weakness of the US dollar may have incentivized domestic investors to sell their foreign capital gains and profit from exchange rates, and redeploy that capital within the US. The Investment Team is prudently watching the path of global interest rates given the Fed’s tightening, and now that Britain, Canada, and the Eurozone are making plans to tighten. The Core Allocation models still continue to outperform their benchmarks, Morningstar World Allocation and Morningstar Tactical Allocation categories. The Investment Team’s asset allocation decisions within the major asset categories are proving to deliver strong results. In addition, the diversifying exposure (such as foreign fixed income and hybrid securities) contained in the Core Allocation models has offered significant benefit since the beginning of the year.