Assessment of Economic Related Valuation Risk As of March 31, 2019

Summary

Current economic conditions, trends, risks and outlook indicate a MEDIUM HIGH level of valuation risk. Significant risks include:

  • U.S. Budget deficit ramifications 

  • U.S. National debt again hits new all-time high at $22.1 trillion.  

  • Rising interest rates from current low rates would significantly impact the U.S. budget deficit. Even though the National Debt increase over the most recent 12-year period was 153 percent, the annual U.S. debt interest cost was down 36% percent. If interest rates return to pre-recession levels, the U.S. debt cost will triple! 

  • Quantitative Easing unknowns associated with the Federal Reserve unwinding its low interest rate monetary policy.  

  • Interest rates are close to inverting where short-term rates exceed long-term rates. Economists believe history demonstrates that when there is at least 10 straight days of inversion of the 3-month / 10-year Treasury yield curve there is a strong likelihood of a recession within 200 to 400 days. 

  • Trade war possibilities and ramifications 

The US economy grew at a healthy pace for the in 2018. Federal Reserve Chairman Powell reported the unemployment rate is around record lows, job gains are strong, wages have increased, consumer spending is steady, and inflation is low and stable. However, the Federal Reserve also informs that over the past two months, financial market volatility has intensified, and “overall financial conditions have become less supportive of growth.”i
The US economy continues to grow, but the rate of growth is slowing. “Consumer spending, which is the lion’s share of GDP, is telling us that the economy could be slowing more rapidly than a lot of people anticipated, especially in the first quarter.” said Sung Won Sohn, a Loyola Marymount University economist.ii Manufacturing is losing some of its momentum and job creation is slowing.iii A significant concern is the lower future growth expectation exists even with the current historically low interest rates and the Federal Reserve yet to unwind its Quantitative Easing program that remains in place since 2008.
There is a mix of positive and negative current conditions and trends in addition to numerous current high risks.  Economists believe that U.S.-China trade tensions, rising US interest rates, falling stock prices, and dropping oil prices could have a negative impact on the pace of economic growth.iv Nevertheless, most economists believe that the odds of a recession in 2019 are low.v  

Key Current Positive Economic Conditions and Trends

  • Low inflation rate with economists forecasting about 2% for the next three yearsvi 

  • Low interest rate environment supporting economic growth. 

  • Lower trend in U.S. regulation supporting economic growth.  

  • Low unemployment with three-year forwarding looking forecasts at 3.6% to 4.0%. The unemployment rate held at 3.8% in March, just above the 49-year low of 3.7%. 

  • Purchasing Managers Index (PMI) at 55.3%, down from 59.3 for December. (PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change. The further from 50 is greater the level of change.) 

  • GDP’s first reading for Q1 2019 GDP growth came in at 3.2% (vs. 2.5% expected), the best start to a year since 2015. Overall, the current 

expansion, which began in June 2009, is now in its 117th month the second-longest economic expansion in U.S. history. The longest span 120 months lasted from 1991 to 2001. However, Economists are predicting lower real GDP growth rates over the next three years (2.7% in 2019, 2.1% in 2020, and 1.7% in 2021) and lower leading indicator results.

  • U.S. nonfarm productivity or the level of employee output per hour – rose in 2018: Q1-0.3%, Q2-3.0%, Q3-1.8%, Q4-1.9%. The Q2 increase of 3.0% was its sharpest gain since a 2.9% climb in Q4 2015 

  • In Q1 2019 the stock markets recovered much of the 19% lost in December 2018.  The S&P 500 is up 7.3% over last year. Expectations that central banks will hold interest rates at low levels has helped US stocks reached their biggest quarterly gains in close to a decade.vii 

  • U.S. Trade Gap shrank again in February after hitting a 10-year high of $59.9 billion in December, the U.S. trade deficit fell to $51.1 billion in January and to $49.4 billion in February, its lowest level since last June. 

  • U.S. vehicle sales remain consistent with and in the historical “high” range. 

  • Housing Starts trends and forecasts are positive working there way back to 50-year averages. 

  • Credit spreads indicate are in a “low” historical range which indicates low economic risk. 

Key Current Negative Economic Conditions and Trends

  • The Federal Reserve Bank of Philadelphia’s six-month leading indicators indexes for the U.S. and Minnesota continue to trend lower since 2012. For 2018 the quarterly forward-looking six-month growth rates were Q1-1.53%, Q2-1.52%, Q-3-1.37% and Q4-1.19%. 

  • Consumer-confidence is trending lower.  After rebounding in February, the Conference Board Consumer Confidence Index fell. Lynn Franco, of The Conference Board says “the overall trend in confidence has been softening since last summer, pointing to a moderation in economic growth.viii     
  • Short-term interest rates are rising with the U.S. 3-month Treasury yield rising .83 basis points from a year ago to 2.39%. Wells Fargo is predicting the Prime will go up .3% in 2019 from its current 5.5%. The recent bond-market rally has pushed long-term yields below short-term yields, causing an inverted yield curve that “has set off alarm bells that a recession may loom around the corner,” says Jed Graham of  Investor’s Business Daily.ix (Treasury rates inverted for five days in March where short-term rates exceed long-term rates.) Economists believe history demonstrates that when there is at least 10 straight days of inversion where the 3-month Treasury rate exceeds the 10-year yield there is a strong likelihood of a recession within 200 to 400 days. 
  • Robert A. Murray, Dodge Data & Analytics economist, reports “the pace of construction starts has been lackluster in early 2019.” Weather, government funding levels, affordability constraints, and a more prudent lending stance by banks have had hurt all sectors of the industry. During the first two months of 2019, total construction starts on an unadjusted basis were down 12% from the same period a year ago.x 

  • Profits of domestic financial corporations fell $25.2 billion in the fourth quarter of 2018, after a decrease of $6.1 billion in the third quarter. 

  • Uncertainty about when the current trade policy tariffs will change.

Key Current Significant Risks to the Economy

  • U.S. Budget deficit ramifications remains a long-standing significant risk. After rising to $666.0 billion in fiscal year ended September 2017, last year Federal deficit jumped to $779.0 billion, a 17.0% percent increase and its highest mark since 2012.  

  • U.S. National debt again hits new all-time high at $22.1 trillion in February. Rising interest rates from current low rates would significantly impact the U.S. budget deficit. The chart to the right illustrates even though the National Debt increase over the most recent 12-year period was 153 percent, the annual U.S. debt interest cost was down 36% percent. If interest rates return to pre-recession levels, the U.S. debt cost will triple! 

  • Quantitative Easing unknowns associated with the Federal Reserve unwinding this low interest rate monetary policy that started in 2008. After remaining flat since 2015 the Fed started reducing the balance sheet in October 2017 but recently has indicated the runoff will be much slower than expected.xi (Quantitative Easing is an unconventional monetary policy in which the Federal Reserve purchases government securities from the market in order to increase the money supply and encourage lending and investment which has artificially lowered interest rates significantly.) 

  • Trade war possibilities and ramifications. 

Leading Indicator Results

The Federal Reserve Bank of Philadelphia’s leading indexes for the U.S. and Minnesota predict the six-month growth rate of the coincident index. In addition, the models include other variables that lead the economy: state-level housing permits (1 to 4 units), state initial unemployment insurance claims, delivery times from the Institute for Supply Management (ISM) manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill. The chart below provides a historical view contrasting the leading indexes with major policy changes and economic periods. Note the trend since 2012 is lower six-month economic growth rate predictions. Also note the Quantitative Easing billions of assets held by the Federal Reserve from 2002 through today.

 

Vehicle Sales

 

Financial Markets

In Q1 2019 the stock markets recovered much of the 19% lost in December 2018.  

The chart below provides a historical view contrasting investment performance since 2001 for major market asset types with major policy changes and economic periods. Note the performances were led by Real Estate, then Gold then Micro Cap Equity followed by Mega Cap Equity. Investment returns in recent years were fueled by lower tax rates. Since 2009 except for Gold, these market assets are trending up with some intermittent minor decreases. The most significant decreases were in 2018.

 

GDP Results and Forecasts

 

The chart below provides a historical view contrasting GDP actual and forecasted growth rates with major policy changes and economic periods. Note that the 2006-2008 recession had the largest negative GDP growth.

 

Inflation Results and Forecasts

 

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2% in February and 1.5% over the last 12 months.xii The Producer Price Index for final demand rose 0.1% in February, seasonally adjusted.xiii The Federal Open Market Committee forecasts that the inflation rate at 2.0 percent in 2020 and 2021. The chart below provides a historical view contrasting the CPI Index and annual inflation rates actual with major policy changes and economic periods. Note starting in 2009 inflation was averaging around the 3% midpoint until 2012 when the average midpoint is 2%.

 

Labor and Employment

 

The unemployment rate is steady at about 3.9%. The January rate was 4.0% and February 3.9%. The 37 Fed Forecasters expect the unemployment rate will increase slightly, predicting an average 3.9% rate in 2018, 3.7% in 2019, 3.8% in 2020, and 4.0% in 2021.xiv  The chart below provides a historical view contrasting the unemployment rate with major policy changes and economic periods. Note current and forecasted unemployment rates are in the 50-year low range.

 

Interest Rates Results and Forecasts

The Federal Reserve at its March meeting suggested it would not raise interest rates in 2019 in a significant about-face that indicates worries about the economy are intensifying.xv As for the FOMC’s interest rate projections —the Fed’s “dot plot”—in December, a large majority of members—15 out of 17—expect between one and three rate hikes in 2019. This shifted dramatically at the March meeting with only six members now expecting one or two rate hikes. The chart below provides a historical view contrasting 10-year and 20-year treasuries rates with major policy change and economic periods. Note the interest rates were recently at 50-year lows and are close to inverting where short-term rates exceed long-term rates. Economists believe history demonstrates that when there is at least 10 straight days of inversion of the 3-month / 10-year Treasury yield curve there is a strong likelihood of a recession within 200 to 400 days.

 

Housing Starts Results and Forecasts

 

Credit Spreads

Credit spreads indicate perceived credit risk in the general economy. For the TED spread, T-bills are considered risk-free while London Interbank Offered Rate (LIBOR) reflects the credit risk of lending to commercial banks. An increase in the TED spreadxvii is a sign that lenders believe the risk of default on interbank loans is increasing. The Corporate High Yield spread represents the credit risk differential between corporate AAA rated securitiesxviii and riskier corporate high yield securitiesxix. The chart below provides a historical view contrasting the two spreads with major policy change and economic periods. Note the spreads generally are in the low range with recent increases and volatility.

 

i “Federal Reserve issues FOMC statement.” Board of Governors of the Federal Reserve. March 20, 2019. https://tinyurl.com/y2zn37k8

iiPaul Kiernan. Consumers’ Cautious Start to 2019 Trims Expectations….” Wall Street Journal. March 29, 2019.

iii “Trump Owns the Economy Now….”  March 28, 2019. New York Times. https://tinyurl.com/yyd74m6s

iv Daniel Kruger. “Economic Doubts Drag U.S. Treasury Benchmark Rate Further Below 3%.” The Wall Street Journal. December 5, 2018.

v Jessica Menton. “Bearing Down.” The Wall Street Journal. December 25, 2018.

vi  “February Construction Starts Descend 3 Percent.” Dodge Data & Analytics. March 21, 2019. https://tinyurl.com/y75k6lrb

vii Akane Otani. “U.S. Stocks Rise, Notching Best Quarter.” Wall St. Journal. March 29, 2019.

viii “The Conference Board Consumer Confidence Index Declined in March.” The Conference Board. March 26, 2018. https://tinyurl.com/klywfub

ix Jed Graham. “Surprise: This Inverted Yield Curve Is Good News For The Dow Jones, Economy.” Investor’s Business Daily. March 29, 2019.

x “February Construction Starts Descend 3 Percent.” Dodge Data & Analytics. March 21, 2019. https://tinyurl.com/y75k6lrb

xi Nick Timiraos. “Fed Officials Weigh Earlier-Than-Expected End to Bond Portfolio Runoff.” The Wall Street Journal. January 25, 2019.

xii Consumer Price Index Summary. Bureau of Labor Statistics. March 12, 2019 https://tinyurl.com/n44gkqz

xiii Producer Price Index News Release Summary. Bureau of Labor Statistics. March 13, 2019. https://tinyurl.com/h6dchdp

xiv Fourth Quarter 2018 Survey of Professional Forecasters. Federal Reserve Bank of Philadelphia. November 13, 2018. https://tinyurl.com/ycropzwn

xv Heather Long. “Federal Reserve Cuts Growth Forecast, Signals No More Rate Hikes in 2019” The Wall Street Journal. March 20, 2019.

xvi “February Construction Starts Descend 3 Percent.” Dodge Data & Analytics. March 21, 2019. https://tinyurl.com/y75k6lrb

xvii Federal Reserve Bank of St. Louis, TED Spread [TEDRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TEDRATE

xviii ICE Benchmark Administration Limited (IBA), ICE BofAML US Corporate AAA Effective Yield [BAMLC0A1CAAAEY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC0A1CAAAEY

xix ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Effective Yield [BAMLH0A0HYM2EY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY