Do My Eyes Deceive Me? Strategic Income Outlook July 2019

The financial press is replete with stories about what possible calamity awaits if the Federal Reserve (the Fed) does not cut the fed funds rate soon. Services that track the odds of a cut (at this writing) are calling with near certainty for one in July. We read every day about sinking optimism, non-existent inflation, declining corporate earnings estimates and how out of step the Fed’s interest rate policy is versus other central banks. We can see how bearish investors’ inflation expectations are with negative yielding debt now standing at a record $13 trillion. Trade tensions are certainly contributing to this angst, but also concern about the record amount of corporate debt globally is keeping the market Cassandras up at night.

At the same time, when we look at how much of this potential future wreckage is discounted in what we call “risk” assets, we find that very little is. The S&P 500 Index (S&P 500) is near record highs, and the ICE Bank of America Merrill Lynch U.S. High Yield (HY) Index yield has broached 6% yield to the downside. Returns year-to-date (as of 6/30/19) are over 18% for the S&P 500 and 10% for the HY market. “Risk-off” assets, such as Treasury bonds and gold, have also climbed sharply, buoyed by low inflation, accommodative interest rates, and slow, steady growth.

Call us crazy but there seems to be a disconnect here. How can the bond market and the equity market be sending such different signals? The situation is confounding, but it is not irrational. Recent economic data has been decidedly mixed, which has allowed investors to divide into different camps. In our view, the most likely outcome is an extension of the status quo. Although some leading indicators are softening, we feel that the slow-growth recovery should continue, albeit with ebbs, flows and potentially some volatility, primarily due to an accommodative Fed and historically low unemployment.

Earnings expectations are one of the data points that have fallen recently. Forecasts for the second quarter 2019, as measured by Bloomberg, have dropped since last September from estimated growth of ~8.5% to a decline of ~2.7%. For full year 2019 the estimates have dropped from ~7.5% growth to ~0.7% growth. Most of the damage is predicted to happen in the second quarter, with a large rebound in the fourth quarter. In our many years investing we have observed that the farther away the time period is, the more optimistic people are. Time will tell, but if we get no meaningful break in the incessant trade wars soon, sentiment will likely deteriorate further, and earnings may well ebb more.