This fall, investors are understandably confused by events in the financial world. On the one hand, many expected the Federal Reserve to raise rates, given signs of strength in the U.S. But then the Fed held off on an expected quarter point increase due to economic weakness overseas. While a U.S. recession may not be imminent, many economies around the world are stagnating. People are also confused by falling commodity prices: is it a good thing for consumers, or is it a sign of deflation? With nearly all asset classes lower on the year, investors may be wondering if another 2008 crisis is just around the corner.
However, Jim cautions against extreme pessimism by pointing to several positive developments overlooked by some:
“We just got a revised estimate for 2nd quarter GDP. It was revised upwards, from 3.7 to 3.9 percent… The housing sector is strong, with homebuilder confidence the highest going back nearly a decade... The homebuilder stocks are doing well, automobiles are very strong…retail sales and consumer spending have been good, the service sector is almost at an all time high—the only weak point is manufacturing [but] it is still expanding while the employment picture continues to improve…”
Jim then reviews the other side of the issue, and explains why Fed officials sounded a more negative note last month on the global economy. First, there is the possibility of spillover from China or from some other emerging economy that owns too much dollar denominated debt at a time when the dollar is strengthening.
Second, many of the measures of financial stress used by the Fed are showing deterioration to levels similar to early 2012, during the PIIG crisis.
Third, most Fed expectations regarding economic growth have been far more optimistic than what markets had anticipated. As Jim points out regarding the Federal Reserve: “their economic forecasts have been off consistently. 90% of the time these guys are wrong. They have to have a bit of a confidence issue.”
Finally, Jim points out that out of 14 tightening cycles since 1954, only one of them (1983) occurred when oil prices were falling. Usually, the Fed waits for some sign of rising inflation before taking rates higher.
As a result, Jim expects that the Fed will not raise rates until financial stress, weakness in emerging markets, and oil reverse course and show signs of improvement. But the important point is that he does see rising rates over time.
As economic growth reaccelerates with higher interest rates, Jim believes the long-term trend is higher for stocks. In spite of recent weakness, Jim maintains that the bullish move from 2009 is still intact. While his firm has raised some cash, Jim points out that the fourth quarter is almost always a good one for equities (even during bear markets), and that he is finding opportunities in dividend paying stocks not seen in many years. Part of the basis for Jim’s optimism again comes from what he sees in the United States:
“Household debt to income, loans outstanding, owner’s equity in real estate and debt service ratios have never been this good… The same thing holds true on the corporate side: corporate net worth, debt ratios, liquidity ratios have never been this good [and] companies are sitting on 2 trillion dollars in cash… This is not 2007-2008.”
Jim also notes extreme pessimism among asset allocators. For him, this is a classic contrarian indicator. As a warning to overly bearish retail investors, Jim jokes how “if you think you are on the ledge ready to jump, look to the left or the right of you, chances are your fund manager is right on the edge with you.” It is probably unwise for retail investors to panic in an environment of extreme fear.
In the second part of the program, Jim and John go on to discuss concerns about bond mutual funds. As most listeners know, Jim has long advocated individual bond ladders for investors, consisting of deeply liquid bond issues, where investors know exactly what kind of interest payments they are going to receive. Jim’s strategy stands in contrast to bond mutual funds, which present several problems for investors. First, the funds are more likely to be a play on the price of bonds rather than on income. In a rising rate environment, double-digit losses can occur, which may come as a surprise to the many boomers owning these investments for “safe” returns. But an even larger drawback to bond funds is that you can potentially suffer when others panic and the fund manager is forced to sell illiquid bonds at unattractive prices. As an example, Jim reviews a recent Wall Street Journal article (see here) explaining the potential liquidity issues with several well-known bond funds.
While those who have been predicting higher interest rates have been wrong for many years, Jim repeatedly reminds investors to take seriously the Federal Reserve’s warning to the markets that rates will eventually go higher. People who are hunkered down in bonds may get an unwelcome surprise when the current economic uncertainty passes.
Listen to this full broadcast with Jim Puplava, President and Chief Investment Strategist at PFS Group, by clicking here. For a complete archive of our broadcasts and podcast interviews on finance, economics, and the market, visit our Newshour page here or iTunes page here. Subscribe to our weekly premium podcast by clicking here.