"Trump Bump" Results Are In

What Now?

The U.S. Bureau of Economic Analysis released the advanced estimate of Q2 GDP yesterday showing an annualized increase of 4.1% (circled in yellow on the above chart). Slightly below expectations of 4.2%. The 1 year moving average (the pink line) of previous quarterly GDP, which smooths out the volatility of the quarter to quarter data, rose slightly to 2.8%.

A scan of the data shows that the consumer played a big part in this increase, despite seeing less income growth and hence a reduction in the savings rate over the quarter. Likely a spill-over of the effects of the lower corporate tax rates that came about with President Trump's tax reforms ("Trump bump").

We don't expect the consumer to be able to sustain this kind of momentum. Higher interest rates on top of record debt and lower income growth will hobble future consumer spending.

Also a surge in exports of goods, likely in advance of anticipated protectionist tariffs was a big factor in Q2 GDP growth. This will be a one-time thing.

Look for this to detract from Q3 and Q4 growth: Higher interest rates and the stronger $US will also start to play into exports as we move forward.

As far as our theme that we are drawing close to the end of the cycle (red arrows in the above chart and see my previous series of blogs), this plays into it perfectly: the proverbial "last gasp".

Q2, which ended on June 30th, is well be hind us (ancient history in our world of forward thinking) and we now have to get a sense of what comes next and that is a continuation of late cycle theory: higher interest rates (monetary policy tightening), a flatter yield curve (heading towards inversion), slower economic growth, reduced earnings growth, lower stock markets.

Friday's stock markets might have finally begun looking toward the future (S&P 500 lower by .66%, NASDAQ lower by 1.4%). Bond markets have have been doing so for quite some time.

Are you prepared?
We (and our clients) are.

Is Your Cost Of Living Rising?

By How Much?

Each month Statistics Canada releases their latest numbers on the changes in the Consumer Price Index (CPI). This month total CPI for the last 12 months increased by 2.5%, which is the largest year over year increase since February of 2012. Last year, the June 2017 CPI (for the previous 12 month period) was announced at 1.0%.

According to Stats Can, transportation costs, especially the price of gasoline as well as food purchased at restaurants were the main culprit for the increases.

Why do we care?

A key assumption in our client Wealth Forecasts is the future growth in the costs of continuing the lifestyle that you wish to pursue. Everybody consumes differently: if you don't drink adult beverages (alcohol and maybe one day, cannabis infused drinks) or smoke, your cost of living may not rise as much as someone who does. Same with driving, if you drive often, perhaps to a weekend retreat, you will likely have a cost of living that increases faster, year to year, than someone who does not.

Stats Can's "basket of goods" that it follows is an average, but individually, few Canadian folks actually fall into that average and even fewer of our clients do. I don't.

Nonetheless, if you are conscientious about your spending habits (and you really should be), it may be a worthwhile exercise to make a year to year comparison of how much you spend and on what.

Here is what Stats Can's basket suggests that the average Canadian household spends on a percentage basis:

Almost 1/2 of spending is on Food (16%) and Shelter (27%). Add in the Household Operations category and you are at 56%.

Add in Transportation and you are at about 3/4 of all spending.

How do you compare?

More importantly, how do we adjust for the future cost of living?

We can assume the average, but that may be misleading when we try to project your future needs. And importantly as the portfolio management team that determines the optimal investing strategy (return per unit of risk), when we determine what kind of asset growth you need to stay ahead of the increase in your cost of living.

The big long-term risk is running out of money. The key short-term risk, is taking too much risk (with your investments) as you try to grow your money from one year to the next.

Again, the difference between gambling and stewardship: Gamblers chase higher returns. Stewards of wealth determine their needs and build a strategy around them.

Need help with the stewardship of your wealth?

We are always happy to do so.

"Doctor" Copper

From Investopedia: "The term Doctor Copper is market lingo for the base metal that is reputed to have a Ph.D in economics because of its ability to predict turning points for the global economy. Because of copper's widespread applications in most sectors of the economy - from homes and factories to electronics and power generation and transmission - demand for copper is often viewed as a reliable leading indicator of economic health. This demand is reflected in the market price of copper. Generally, rising copper prices suggest strong copper demand and , hence, a growing global economy, while declining copper prices may indicate sluggish demand and an imminent economic slowdown."

In the chart above, you will notice the correlation between copper (blue) and the S&P 500 (orange). You may also note the the price of copper has plummeted in recent weeks.

For us (at High Rock) that is just another of the caution flags that have been raised and a further contributor to our theme that we are approaching the end of the cycle of economic expansion.

Usually, the end of the cycle indicates economic slowing and possibly a recession. Stock markets do not like recessions.

Prepare yourselves accordingly. At High Rock, we are prepared.

End Of Cycle: IMF World Economic Outlook

http://www.imf.org/en/Publications/WEO/Issues/2018/07/02/world-economic-outlook-update-july-2018

"The balance of risks has shifted further to the downside, including in the short-term".

Friends, this is certainly some confirmation of what we have been suggesting was our view over the last few blogs: that the economic expansion is late in the cycle and the risks of a downturn are rising.

"Possible triggers include rising trade tensions and conflicts, geopolitical concerns, and mounting political uncertainty. "

"Tighter financial conditions could potentially cause disruptive portfolio adjustments, sharp exchange rate movements, and further reductions in capital inflows to emerging markets, particularly those with weaker fundamentals or higher political risks."

Interestingly this follows an increase in client concern over how we are positioning our collective portfolios. Here is a bit of a recap:

1) We are over-weight cash equivalent assets, but have used some of those assets recently to purchase US Government 2 year notes (high degree of safety) to get yield of 2.5%.

2) At the same time we continue to be under-weight global equities (to contain our risk exposure). The dividend yield on the S&P 500 is currently at about 1.8%, so we are actually being paid more (2.5% vs. 1.8%) to hold less downside potential.

If stock markets decline 10-20% over the next 2 years and instead you own bonds that will mature at their par value (i.e. you receive exactly what you invested upon their maturity), you will be considerably better off than if you had a fully invested, balanced 60% equity / 40% fixed income portfolio that experiences a significant devaluation in the 60% of equity assets that you own.

Importantly, the compounding benefits of being fully invested would probably take years to catch up to the more tactically active portfolio, with a more defensive posture.

As this occurs, you will, in time, likely see a large shift from passive portfolio investment (which has grown significantly, largely due to the long upward trend in stock prices) to a more tactical style of portfolio management.

Our High Rock Private Client portfolios will have an advantage when the next cycle begins as they will have preserved a good portion of their net worth and be ready to purchase cheaper (better value) equity assets as the U.S. 2 year notes mature (or perhaps before that).

The end of the expansionary cycle is upon us. It is time to prepare for the next stage.

End Of Cycle: Rising Short-Term Interest Rates,

Falling Long-Term Bond Yields

In keeping with our latest theme that we are at or near the end of the economic expansion that began in 2009 (with the exception that in 2016, oil price declines caused a brief retraction of the Canadian economy): short-term interest rates are rising.

The Bank of Canada raised its "overnight" lending rate, as expected, by 1/4%. If you borrow at prime, your cost is now 3.7%. 

If you borrow to invest, a balanced portfolio, in the first half of 2018 likely returned less than 1% (depending on the balance and asset allocation strategy). You will not be on the positive side of that equation.

Probably a good time to consider, for the time being anyway, to consider your options and use under-performing assets to pay down your lines of credit or margin.

As we often suggest bond markets lead all financial markets and in Canada, the yield curve, which we have been following closely, continues to flatten:

The spread from 2 year Govt. of Canada bonds to 30 year Govt. of Canada bonds has narrowed to 0.24%. The 30 year bonds now yield about 2.2%, down from 2.5% a couple of months ago. Longer maturity bond prices are higher. This is good for our collective portfolios because we have structured the average length of our bond maturities to take advantage of this situation. You don't get that tactical advantage from owning a bond ETF.

Bond investors are telling us that they want the safety of Govt. bonds and longer term maturity dates because they do not fear inflation (i.e. economic growth that causes inflation) as the economic cycle draws to its end. Which, in essence, is the sense that both the Bank of Canada and the U.S. Federal Reserve are going to speed up the end of the cycle with their tighter monetary policies.

Meanwhile households are paying more to service their debts and consumers will have to consider their spending habits, especially if they are unable to hold their jobs in the wake of an economic downturn.

For stock market investors, especially those who borrow to invest, the costs no longer justify the risk.

Better to wait for the new cycle to begin, when interest rates are lower and stock prices offer better value.

End Of Cycle: Unemployment Rising

The last three U.S. recessions (blue shaded areas in the chart above) began shortly after the unemployment rate (white line in the chart above) bottomed, then ticked up (usually as more confident job seekers re-entered the labour force) to intersect (and rise through) the 3 year moving average of the unemployment rate (gold line in the chart above). 

On Friday, the U.S. bureau of Labor Statistics announced that the June rate of unemployment moved higher by .2%, from 3.8% to 4.0%, as the number of those seeking work increased.

The 3 year moving average of the unemployment rate is now at 4.6%, the gap between the current rate has narrowed to .6% (highlighted area in the chart above).

In Canada, the unemployment rate also climbed .2% to 6.0%, also with an increase in the labour force).

Economists and the Media chose to focus on the growth in employment (U.S. non-farm payrolls were higher by 213,000 and employment rose by 32,000 in Canada) and now expect that the U.S. Fed and the Bank of Canada will both raise rates by another 1/4%: the BOC as soon as Wednesday of this week, the Fed in September.

With household debt at record levels in both countries (and plenty of $US debt on a global scale), servicing costs for that debt are rising. It will be a problem. Consumers will have less to spend. 2/3 of the domestic economy will come under pressure. Escalating global trade war issues will not help ease this situation.

Economic confidence is crucial to spending decisions: if this slips, both businesses and consumers will postpone decision making and as has happened in all of the end of the cycles that we have previously experienced, GDP growth will slow.

Bond markets have been building this in with flattening yield curves, warning us that we are late in the current cycle (and bond markets always lead other financial markets). Stock markets are still expensive and will at some point in the not too distant future, begin to build this in as well (see my blog from last Wednesday).

Prepare yourselves accordingly.

Bottom Of The 10th / Top Of The 11th?

As economic cycles go, since 1945 the average expansion (US economy) has been 58 months. The longest was from 1991 to 2001.

The most recent expansion began in 2009 and in baseball terminology, is now well into extra innings. As I suggested on BNN Bloomberg a couple of weeks ago, it may well have already ended but for the "Trump Bump" (circled in yellow above) which has added a round of fiscal stimulus that likely extended the expansion. But, as history shows, at some point the economic expansion is always followed by a contraction and this time will be no different.

In terms of the US equity market over this cycle so far:

Early in the cycle, less confident investors need to be convinced that indeed things are going to get better (many were scared off by the volatility of 2008-09). Earnings (EPS) usually have to lead stock prices higher to convince investors to participate. Taking higher levels of risk through this period (when actual risk is really quite low) is prudent.

As the cycle progresses and investors become more confident, share prices begin to take the lead as earnings are now expected to grow. But as the cycle moves into its later stages, with investors extremely confident, stock prices get ahead of themselves (too expensive) and the risk of a reversion to the mean increases and the risks associated with equity ownership become significantly greater. This is a time to be reducing exposure to stocks.

Emotions play a big factor in all of this. As I suggested in my discussion with Paul Bagnell (BNN Bloomberg), we don't "advise" clients to take risk off of the of the table, we do it for them. If we left it to them, the euphoria of seeing stocks rise (as they did in January), may provide a false comfort and the ensuing tumble (as they did in February) a scare that may result in panic.

As portfolio managers, we manage the risk because that is what we are paid to do. So it is no surprise that while the benchmark we use to measure ourselves against is up less than 1% in 2018 to date (after a tumultuous 1st half of the year), our High Rock Private Client portfolios are (depending on their allocation strategy and length of time as clients) well above 1%.

Our longer-term client (5 year) return per unit of risk taken (after fees) remains well above that of any of the benchmarks (before fees):

We are obviously doing something right by taking risk off of the table: reducing risk in this late stage of the cycle to protect our clients (and ourselves) from the inevitable end of the cycle and still getting better than benchmark returns.

As the regulators insist we state: past performance is not a guarantee of future returns. However, as most of you know, we at High Rock work darn hard to get the best possible risk-adjusted returns for our collective portfolios. 

Some of the "chief" economists research and/or opinions that I have read lately were only graduating with their economics degrees at the beginning of this cycle. How can they possibly advise on how a cycle will play itself out?

We do not give investing advice. We give wealth advice and build portfolio strategies for our clients in keeping with their specific needs, goals and time lines (which may be over many cycles into the future). We manage the risk using our vast experience of doing so, over many of the past economic cycles (at least since the early 1980's).