Welcome to the October 2019 newsletter! Today, we’ll update you on the Federal Reserve and Treasury, broad options for conservative investing, recommended actions for your stock and bond portfolios, and more. Let’s get started!
Summary
Our economic growth is decelerating due to the ongoing trade war with China and the global growth slowdown. Most of the real-time economic data we monitor remains weak with the U.S. manufacturing sector in contraction. But most importantly, a recession is not going to begin in 2019. All portfolios remain fully invested.
Employees should continue to make their weekly or monthly contributions to their employer’s retirement plan or IRAs. Additional money can be added to an investor’s stock market allocation, but only on a dollar-cost-average basis.
The Economy
Employment
U.S. nonfarm payrolls rose in August by 130,000. This was slightly lower than expected. The July payroll number was revised down from 164,000 to 159,000, and the June number of 193,000 was revised down to 178,000. The rolling three-month payroll average increased from 140,000 last month to the current figure of 156,000. Unemployment was unchanged at 3.7%.
Even with payrolls only increasing by 130,000, the total number of people finding jobs is greater than the number of young people who are first entering the workforce. U.S. employment is in good shape unless you are an employer who is having trouble finding qualified applicants.
Gross Domestic Product
The U.S. economy grew at an annual rate of 2.0% after inflation in the second quarter of 2019. This is the Bureau’s third estimate of the second quarter; the first estimate was 2.1%, and the second estimate was 2.0%. This quarter’s GDP reflects positive contributions from personal consumption expenditures and federal, state, and local government spending and exports.
Inflation
Annual inflation remained constant in August at 1.4%, as measured by the Personal Consumption Expenditures (PCE) index. The core PCE index, which excludes food and energy, rose slightly to 1.8%. All numbers represent changes from the same time one year ago.
Long-term inflation expectations can be determined by calculating the differences between Treasury bond yields & TIPS real yields of the same maturities. Results are:
| Bond Maturities | Annual Inflation Expectations |
| 5 Year | 1.35% |
| 10 Year | 1.53% |
| 30 Year | 1.59% |
Inflation numbers above were mostly unchanged compared to the previous month.
Stock Market
Commentary
Let’s look at our five pre-recession indicators:
Annual Inflation: CPI is at 1.7%, and core CPI is 2.4%. PCE inflation is at 1.4%, and core PCE is at 1.8%. Conclusion: inflation is under control. Low inflation is a key factor in allowing the Federal Reserve to maintain accommodative monetary policy.
Payroll Growth: The healthy flow of new jobs supports our view that the economy can move forward despite the trade dispute with China.
Rising Unemployment Claims: The trend of initial unemployment claims has been favorable in recent years, and the key four-week moving average remains near its 50-year low.
Inverted Yield Curve: An inverted yield curve typically occurs due to the Fed increasing short-term interest rates as they try to control inflation during a mature economic expansion. Today though, we have tremendous buying of long-term U.S. Treasuries by international investors and institutions, which is driving the price of these securities up and their yield down. See more info on the yield curve below.
Leading Economic Index (LEI): Although the LEI continues to suggest modest economic growth, the pace of expansion has waned under the pressure of the weak manufacturing sector and the U.S.-China trade war. See more info on the LEI below.
Conclusion: These indicators tell us our economy is growing, but not as fast as in the past. The manufacturing sector is in a recession, and the world economy is slowing, but signs of a recession are only weak at this point. All portfolios remain fully invested in a highly diversified, low-cost, and tax-efficient approach.
Will the following two leading indicators predict the next bear market?
1. The U.S. Treasury Yield Curve as of September 30 is below.
The yield curve this month is significantly less inverted than last month. The lowest yield is 1.55% at 5 years. The 30-year minus 3-month spread recovered last month to +24 basis points. A basis point is 0.01%. The important 10-year minus 2-year spread improved to +5 basis points. The only yield curve we monitor that remains inverted is the 10-year minus 3-month spread, which is currently at -20 basis points. Last month, this spread was -49 basis points.
Conclusion: Although the yield curve has established an admirable record of inverting prior to a recession, it has also inverted a few times without a recession. Normally, the yield curve inverts because the Fed is raising short-term rates. This time, the Fed is lowering rates, and this is an important difference.
2. The Conference Board said the Leading Economic Index (LEI) remained constant in August compared to a revised 0.4% increase in July.
The LEI spokesperson said, “The recent trends in the LEI are consistent with a slow but still expanding economy, which has been primarily driven by strong consumer spending and robust job growth.”
Conclusion: The LEI is suggesting the economic expansion that began in 2009 is continuing. Over the past 60 years, the LEI has fallen ahead of each recession, and the July reading was a new cycle high.
Stock Market Valuation
We continue to estimate the 2019 S&P 500 Index operating earnings will be $167. Our 2020 estimate is $175. Based on our price/earnings ratio range estimate of 17 to 18 times operating earnings, our S&P 500 Index target range for some time next year is the mid 3,100s (175 x 18 = 3150).
In the short term, the above stock market valuation is threatened by the President’s trade war with China. In the medium term, this stock market valuation is threatened by the possibility of an anti-business, high-tax presidential candidate winning the election next fall. If that happens, our estimate is: BOTH corporate profits and the PE ratio will drop. Perhaps we might see $160 x 15 = 2,400 on the S&P 500 Index. That would be a 21% drop from our recent July 26 closing high.
Recommended Action for Your Stock Portfolio
Our 10-year stock market outlook is below. We have enjoyed the Total U.S. Stock Market Index, VTI, giving us a 13.1% average annual return over the past 10 years. This WILL NOT continue, as the average annual return since 1926 has been 10%. Therefore, we will have several to many years with an average return below 10% to maintain the historical average. Below are our 10-year average annual return estimates:
| U.S. stocks | 3.5% to 5.5% |
| Global stocks | 6.5% to 8.5% |
| U.S. bonds | 1.5% to 3.5% |
| Global bonds | 1.0% to 3.0% |
| U.S. Real Estate | 2.5% to 4.5% |
| Cash | 1.0% to 2.5% |
| Inflation | 2.0% |
Therefore, we recommend investors’ stock market allocations should be fully invested in a low-cost, highly diversified, and tax-efficient portfolio. Additional money can be added to the stock market, but only on a dollar-cost-average basis.
Broad Options for Conservative Investing
Over the next few months, we will review the broad options for our four categories of conservative investing. They are in order:
- Savings
- Very conservative investing
- Lower risk, lower volatility, and (over the long term) lower return investing
- Medium risk, medium volatility, and (over the long term) medium return investing
This month, we will discuss “Savings.”
First, an investor’s multi-year average return of their conservative investments expressed in real terms (after taxes and inflation) should be positive. We do not advocate “let’s plan on losing money after subtracting taxes and inflation.”
Real Return = (actual return times (1 – marginal income tax rate)) – rate of inflation
An example:
* An investor’s multi-year average rate of return of their conservative investments has been 3% before subtracting taxes and inflation.
* At the margin, their federal + state + local income tax rate is 29%.
* Inflation has been running at 2%. Have they really made money?
Investor’s Real Return = (3% x (1-.29)) – 2%
Investor’s Real Return = (3% x .71) – 2%
Investor’s Real Return = 2.1% – 2% = +0.1%
Yes, they made money, but very little. Keep in mind the only account type that will never pay income taxes is a Roth IRA. Even with a 401K, a traditional IRA or an annuity, someone is going to pay income taxes on the withdrawals – if not you, then your beneficiaries.
The most important thing about “Savings” is that this is probably where you keep your emergency fund. A family should have six to nine months of expenses in their emergency fund. This money should not be invested for growth or income. This money needs to be liquid and safe.
Beyond an emergency fund, “Savings” is not required! An investor can go straight to investing after accumulating their emergency fund. Here are our “Savings” categories:
- Short-term Treasury bill funds
- U.S. savings bonds
- I-bonds
- Bank or credit union government-insured CDs
- Bank or credit union government-insured checking or savings accounts
- Bank or credit union government-insured money market accounts
WARNING! Very likely “Savings” will lose value after taxes and inflation! Please, everyone, minimize your “Savings” beyond your emergency fund. Lorenz Financial does not recommend any of the above six categories of “Savings” except #5 and 6 as good places for your emergency fund.
Next month, we will discuss “Very Conservative Investing.”
Bond Market
Commentary
The Federal Reserve Bank of New York (the most important of the 12 banks) was caught flat-footed in September as rates in the overnight “repo” market spiked to unprecedented levels. The bank president, John Williams, who has no stock or bond market experience, said, “The issues were worse than we expected.”
The Fed’s most recent economic predictions are below:
| 2019 | 2020 | |
| Real GDP | 2.1% to 2.3% | 1.8% to 2.1% |
| Unemployment | 3.6% to 3.7% | 3.6% to 3.8% |
| PCE Inflation | 1.5% to 1.6% | 1.8% to 2.0% |
| Core PCE Inflation | 1.7% to 1.8% | 1.9% to 2.0% |
Federal Reserve
The Federal Open Market Committee (FOMC) met on September 17 and 18. At this meeting, the FOMC cut the Federal Funds rate by 25 basis points to the range of 1.75% to 2%.
There are 19 members of the FOMC. Seven are governors based in Washington DC. Currently, there are two open positions. Their term of office is 14 years with one governor position coming due every two years. The other members of the FOMC are the 12 Federal Reserve Bank Presidents. On a rotating basis, only five presidents can vote at any one meeting.
At the September meeting, only 10 members had voting rights due to the two open governor positions. At this meeting, the vote was 7 to 3. Seven members voted to lower the Federal Funds rate 25 basis points, two voted to keep rates where they are, and one voted to lower rates 50 basis points.
U.S. Treasuries
The latest Congressional Budget Office (CBO) figures show the federal deficit exceeded $1 trillion through the first 11 months of fiscal year 2019. Total receipts were up 3% in the first 11 months totaling $3,087 billion. Total outlays increased 7% in the same timeframe to $4,154 billion.
Recommended Action for Your Bond Portfolio
Our bond market recommendations have not changed since last month. We are recommending bond investors only participate in the following types of bond mutual funds or bond ETFs:
- Short-term, investment-grade U.S. bond funds
- Intermediate-term, investment-grade U.S. bond funds
- Very short-term, high-yield U.S. bond funds
- Ginnie Mae bond funds
- Conservatively allocated U.S. balanced funds with 30 to 50% in stocks, the rest in bonds
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.