Perhaps you have heard of the “Three C’s” of effective communication…the sender’s message should be clear, concise and consistent. For the better part of the past two years, the primary investment themes could be boiled down to the “Three Cs”, China, Commodities and Central Banks. Fears of a “hard landing” for China’s economy have persisted, commodities have been in a bear market until recently, and the Federal Reserve (“the Fed”) tried to convince the markets that rates would be increasing as soon as the next Federal Open Market Committee (FOMC) meeting. While China and commodities have been in the spotlight at various times over this time period, that spotlight has moved squarely to the Fed since the FOMC’s April meeting minutes were released on May 18th.
The April minutes revealed that more than a few Fed governors were in favor of raising rates again as early as the June meeting. Markets were anticipating a more dovish stance because recent economic data indicated the economy is barely growing and consumers are spending less than expected. Investors caught leaning the wrong way scrambled to reposition their portfolios and sent interest rates on U.S. Treasuries of all maturities higher. Markets are now pricing in at least two rate increases this year; a significant change from the 50/50 chance of one rate increase in December prior to the release of the April minutes.
We recognize the Fed’s desire to raise rates to “normalized” levels but current data on the global economy likely won’t allow the Fed to raise rates very far. Global economic growth remains weak. Brazil, the world’s 7th largest economy, is in a full-fledged recession. In Europe, the economic growth rate is not far behind that of the U.S. Yet, the European Central Bank (ECB) continues to maintain their “easy money” stance. The ECB, along with Japan and Switzerland have found buyers for their sovereign debt that carries NEGATIVE interest rates. Several nations continue to weaken their currencies relative to the U.S. dollar in an attempt to boost exports. For the Fed to succeed in its quest to “normalize” interest rates, global economic growth needs to improve to the point that the central banks in the rest of the developed world will be able to abandon their “easy money” stances and begin to tighten.
In addition, we follow several recession indicators and right now none are indicating that a recession is likely over the next 6-12 months. Equity valuations are above long-term averages but still offer more attractive expected returns than bonds. We expect volatility in the stock markets to remain elevated and would not be surprised if markets experience another correction before the end of the year. In this environment, the “Three C’s” of our investment thesis are continued focus on high quality stocks with consistent earnings that are well positioned in a challenging economic environment.