How The Presidential Election Could Impact Stocks and Bonds

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U.S. investors find themselves on the verge of a historic election clouded by controversy not seen in decades, even lifetimes.  Combined with mixed messages in related areas: A rare strong GDP number (subject to revisions), a Federal Reserve on and off with raising interest rates (they are on again for a December hike) and a positive bias to earnings season so far; it seems anything could happen.  The circus we are witnessing between government, candidates, news reporting (and of course WikiLeaks) is exposing the worst in humanity.  Who would have thought a computer shared between Huma Abedin and Anthony Weiner would have trumped (sorry about the pun) all the email stories to date!

Investors would be naive not recognize the potential for coordinated manipulation of asset markets.  We know global banks were recently fined for manipulating LIBOR interest rates and there have been many previous instances of bad behavior in the industry.  That is why Dightman Capital focuses on combining multiple well-constructed strategies for a growth portfolio designed to weather a variety of market and economic conditions using straight-forward investments in specific combinations.  Let us know if we can help you find investment success in a world of uncertainty.  Based on Friday’s response to the breaking Weiner email story from seized electronic devices, more short-term stock market volatility should be expected.

In another sense this market environment is no different from what we have experienced throughout the current administration:  An ability over the last 8-years to guide the news narrative along with markets.  All of that may be about to change, or is it?  Time, it turns out, may be the biggest enemy to current economic and market conditions.  I would caution against taking too bearish a view.  We simply do not know the threshold where markets reject monetary expansion.  Outside of a surprise event that derails markets, current conditions of an upwardly trending stock market, mediocre economic growth and lower than normal interest rates are likely to mostly remain in place via the big fiscal ambitions of both presidential candidates.  Most elections have little impact on markets direction near-term and that would be more true if this was not such a controversial election.

After this year’s election results are announced we might see near-term volatility like the U.K. market reaction to the Brexit vote back in June.  U.K. stock investors have taken the development in stride since the vote with stock prices trading just below levels prior to the vote.

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Many stock markets have been trending sideways since this summer; one reason markets could eventually return to rally mode later this year or early in 2017.  The chart below compares U.S. stocks (IWV), International Developed Country stocks (EFA) and International Developing Country stocks (EEM).

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Bond markets are a different matter altogether.  Instead of trying to hold an 8-year rally, like the stock market, bonds have a multi-decade rally to contend with.  A rally that has pushed interest rates to minuscule levels.

The Fed has signaled they would like to move forward with a rate hike in December and the futures market is currently pricing a 70% likelihood.  Regardless of Fed action bonds are due for a pullback as prices have risen above the top of a multi-decade channel.

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More evidence of higher rates can be seen in the price action of interest rate sensitive industries like real estate investment trusts (IYR) and utilities (XLU), both of which have come under pressure.

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Markets are always only a crisis away from sending bond prices higher and yields lower as investors look for a safe-haven.  With no shortage of international and domestic tension on the rise, we can’t count that out.  But outside of a surprise scenario bond prices look headed lower in the near-term and probably over the intermediate term as well.

Once the election dust settles stocks look poised to continue their advance on the back of new fiscal policy and ongoing monetary policy.  If the next president can pass a fiscal spending package it might be just the cover the Fed needs to continue raising rates.  A couple trillion $ directed into the economy could go a long way towards sustaining the current path for stocks.  Regardless, it looked like the next president of the United States will either be a wildcard potential change agent or a president marred in controversy.  The market will likely discount some controversial headlines as long as credit conditions remain favorable and economic growth is maintained.  Changes in either of those two areas and the next President might find the going a bit tougher than the last one.

The Stock Market Prepares for Higher Interest Rates

U.S. stocks have been stuck in a trading range since the middle of July. Q3 earnings and central bank policy are likely to be the factors driving near-term market direction but any number of wildcard events could derail a rally attempt. The market is currently priced for perfection but that does not mean it can’t go higher. In 10 years is it likely to be significantly higher.

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Q3 earnings expectations are not very high. Market consensus currently suggest this will be the sixth straight quarter of earnings declines. An earnings contraction of this duration has never happened before without a market correction. It is possible the two swift stock market sell-offs and recoveries over the last 12 months were all that was needed but the earnings picture has not improved suggesting a repeat is likely.

Talk of a Fed rate hike later this year (after the election) has pressured bond prices as well as gold. After a very strong rally earlier this year gold has corrected over 8%. Real estate and utilities have also been hit by potential rate hikes.

European stocks are starting to waver again but Asia and Latin America regions have been able to maintain the uptrends they started around the start of the year.

On the bond side of the market, the biggest surprise might be how well corporate junk bonds have held up. The recovery in crude oil prices appears to have taken some of the pressure off the highly leveraged energy market.

We have definitely seen a change in market character as we transitioned from summer to fall. To give you an idea here is how some asset classes have performed over the last 90 days.

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The market appears to be telling us interest rates are going to adjust up which has caused most bonds, gold and real estate to fall after being darlings earlier this year, especially gold and real estate.

Money is still being put to work in high-growth stocks and markets which explains why the Nasdaq 100 and most emerging markets are outperforming developed market large-cap stocks. Also, in Europe and Japan central bank policy remains more active (although Japan has stepped back a bit), where stocks are still responding favorably.

What we are experiencing is a classic adjustment period where markets are taking into consideration the impact of higher interest rates on the short end of the yield curve and the potential impact to longer bond maturities.

Exposure to high-growth mid-large cap U.S. and emerging markets stocks has helped maintain portfolio value over the last few months. So far shorter maturity bonds have only experienced small declines but further weakness might indicate a market that expects the economic recovery to accelerate with more rate hikes to follow. Don’t count on it, there is sparse data suggesting anything of the sort.

As I have said before, margin debt is the one area where higher rates could aggravate stocks. Margin debt peaked 18 months ago so it is entirely possible the next ramp up on stock prices will be a function of levering up again assuming the costs are not prohibitive – we are likely a long way from that problem. Who really thinks 3-month T-bill rates will normalize at 2.6% anytime soon?

There are plenty of strategies for positioning your retirement assets in this market for long-term growth or a margin of safety. Let me know if this is a subject you would like to discuss in more detail.

Retail Sales, Inflation & Real Estate

Doug Short just updated his Big Four Economic Indicators report with July retail sales.  Doug’s report is one of the easiest ways to get a feel for broad economic activity in the U.S.  After a bit of a slowdown scare as we left 2015 and entered 2016, numbers have stabilized and even improved in the case of industrial production, which has contracted in 7 of the last 12 months.  Retail sales came in flat for the month.

It is worth scrolling through the first few pages of the report where lots of graphs and grids are illustrated.  For example, the data grid under the graph of all 4 data economic categories (Employment, Industrial Production, Real Sales, Real Income) shows a continued choppy environment.  The biggest issue lies at the feet of industrial production so it was nice to see some improvement their but it remains well off of recent highs.

Overall, the U.S. economic picture continues to produce slow growth and low inflation.  On the inflation note, individuals experience different impacts  from price increases from different goods and services depending on their current expenditures which is very evident in the breakdown of inflation in this article by Jill Mislinski.

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One of the few pillars of economic activity that continues to provide hope for the future is residential real estate activity but it is starting to look like housing permits peaked at the end of 2015. This could be an important development to keep an eye on.  Jill Mislinski provides more detail in this short report.

As we move into Q3 not much has changed in U.S. economic activity.  As long as real estate markets remain healthy we should be able to maintain the path we are currently on.

Don’t Let An Old 401k Languish

Old 401kAfter a 25+ year career it is not uncommon for an individual to have worked at several different employers and each employer may represent an old retirement account.  Many times I have helped a client consolidate old retirement accounts (401k, 403b, 457, and others) into an IRA or Roth.  The process is often referred to as a “rollover”.

There are a lot of factors to take into consideration when making the decisions to rollover an old retirement account.  Factors like the control, expenses and investment options.

There are tax considerations as well.

If you are interested in learning more about your rollover options let me know and I will pass along a report on “Consolidating Old Employer Retirement Accounts”.  It provides more detail on the decision.  I’m also available to discuss the subject so give me a call at 877-874-1133 or email me at INFO at DightmanCapital.com

What A June Rate Hike May Mean for Stocks, Bonds & Real Estate

In order to assess the potential impact of an interest rate hike on asset markets it may help to understand the possible motivation behind the Fed’s decision.  While they point to an improving economy, outside of their employment mandate there is little reason to raise rates.  The Fed has also been clear about their desire to normalize interest rates and this is likely the reason policy makers will raise interest rates at the next available opportunity.  The Fed is trying to get rates up to a point where when the economy falls into a recession they will have the ability to lower rates.  Its important to understand that under the typical interest rate cycle the Fed is usually raising rates as the economy is about to overheat and create inflationary pressures.  That is not what the Fed is trying to do in this cycle.

So what can we expect if the Fed raise rates in June?  Last summer when rate hike talk surfaced the stock market responded poorly and experienced a swift and deep correction.  By December stocks had staged a recovery and the Fed raised rates a quarter point.  Markets proceeded to sell off aggressively as we entered 2016 only to recover by mid-April.

Will we see the same reaction from the stock market this time?  Maybe not.  Stocks have held up recently despite a mixed Q1 earnings season.  Wednesdays initial stock market reaction to the Fed minutes was based on the surprise a rate hike was firmly on the table for June.  At the time the futures market was projecting around a 5% chance of a June hike.  It’s only around a 35% as of today.  However, markets closed even on the day of the Fed release after being down earlier.  On the following day they recovered a good portion of their moderate declines.  As the stock market approaches the close of the week stocks are staging a rally.  So far stocks appear to have taken a potential rate hike in stride.  (I will post this note before the market close so take note of how they end the session for clues on how they may respond going forward.)

The bond market, on the other hand, could start to come under pressure.  Bond investors have experienced a 35-year bull market and a move back to historical rates would cause fairly significant price declines for bonds with longer maturities.  The bond market has moved to new highs since the December rate hike so the first hike had zero impact on the broader bond market.  Bonds reacted poorly on the date of the Fed minutes release but stabilized the last couple of days.  However, if the bond market sense more rate hikes are coming later this year you can expect downward pricing pressure to materialize.  Depending on how high rates move the good news is investors will finally be able to receive a higher yield on their fixed income investments.  But don’t count on it, we could easily see negative rates here in the U.S. before we see a 30-year Treasury bond yielding 5%.

The big risk for the Fed with a rate hike is the impact on the real estate activity.  Whether you are talking about new construction, remodeling, refinancing and resale activity in both commercial and residential segments, activity is up.  There is talk of a bubble in some markets and some ultra-high-end markets are seeing a slowdown, but generally speaking real estate activity appears to be good.

Part of the strength in real estate can be attributed to low interest rates and available credit markets.  Rates have been higher at various stages of the current recovery so there is probably room for some hikes before rates start to deter the real estate market.  We don’t know at what level interest rates will start to deter real estate borrowing and that is the tightrope the Fed must walk.

As I have said for many months, I believe healthy real estate activity is key to keeping this economy going.  I don’t think a rate hike in June is going to derail things here in the U.S. and I expect one in June unless something significant changes between now and then.  So far it looks like the stock market is going to take the hike in stride.  The bond market, on the other hand, could come under pricing pressure especially if it feels additional hikes are coming.  Real estate activity, I believe is the most critical component and one the Fed will not want to disrupt.