Thought Leadership Series: Potential Risks and Rewards in the Investment Outlook

June 29th, 2017

With the markets at all-time highs, many investors are wondering when the next recession will be and what the economic and investment landscape looks like going forward.  To help address these concerns, First Long Island Investors invited Bob DeLucia, CEO and founder of Veritas Economic Analysis, LLC to join clients and friends of the firm for a breakfast seminar on June 21, 2017.  Bob DeLucia is an independent consulting economist who held senior economist positions at Prudential Financial and CIGNA before starting his own firm.

Robert D. Rosenthal and Bob DeLucia

Robert D. Rosenthal and Bob DeLucia

Bob began the session by sharing his point of view on investor sentiment, the economy, and the markets.

  • He believes we are living in a complex and confusing time in history and much of the confusion comes from misinformation provided by the media, politicians, and Wall Street.
  • Historically the most important concerns for investors have been inflation and interest rates, but more recently the greatest concern involves gauging the timing of the next recession.
  • We are entering the ninth consecutive year of an economic expansion cycle, which started in June of 2009. This is the third longest business expansion since 1850 with the longest being the 10-year expansion cycle of the 1990s.  Given current underlying conditions, the current expansion should surpass that one.
  • Business cycles approach maturity based on underlying conditions including high inflation, restrictive monetary policy, worsening credit conditions, and shortages of materials, capacity, and labor. Market conditions today are not consistent with those of an impending recession and Bob does not expect a recession to occur in 2017 or 2018, at a minimum.  However, Bob is concerned with our economy being near full employment
    • With the unemployment rate at a 16-year low, one would expect to see accelerating growth in wages. This has not yet happened, but will likely happen soon
  • The best forward indicator of a recession is the slope of the yield curve. An inverted yield curve has never failed to predict a recession in the post-war era. Once inverted, the typical lead time to a recession is usually 12-15 months.  Currently the yield curve has flattened somewhat, but is not close to being flat and will most likely steepen again before it becomes inverted.
  • Bob reiterated that given all of these factors, there is a low probability of a recession occurring anytime in the next 18 months.
  • Bob feels we are most likely in store for an acceleration of growth over the next year or so based on the assumptions of GDP growth of 2.5% to 3.0% over the next four quarters. His forecast also assumes an inflation rate of around 2% in 2017 and 2.5% in 2018 (which will be driven by wages), corporate profit growth of approximately 10-12% over the next four quarters, and continued low unemployment.
  • Equity Market View:
    • 3-6 months: It is nearly impossible to say what will happen because markets are unpredictable and random in the short-term.
    • 12-18 months: We are currently in the sweet spot of the business cycle: Over the next 12 months, GDP growth should accelerate; corporate profits should increase at a rate in excess of 10%; inflation should remain below 2%; and the Federal Reserve will likely raise short-term rates at a moderate pace.
    • Long-term: Bob expressed some long-term concern over the high valuations on earnings. Currently the price-earnings ratio on S&P 500 companies is 18, while the historical average is 16 to 16.5.  Investors must keep in mind their entry point when gauging expected rates of return. Assets invested when valuations are high (like today) will earn less annually than those that were first invested when multiples were lower.
    • Bond markets are currently in a bubble, especially government bonds. Too many people are comfortable in bonds and the price of all fixed-income assets are divorced from fundamental reality.
    • Companies are reporting high earnings and high revenues which is good and should continue to help performance of their stocks.

After sharing his initial views, there was a question and answer session led by Robert D. Rosenthal, Chief Investment Officer of First Long Island Investors.

Question:  The Fed has been talking about raising rates and reducing its balance sheet.  How will this deleveraging affect markets?

Answer: The Fed has stated that it will continue to raise rates and so far the market has reacted positively to the increases.  In addition to raising rates, the Fed will begin to shrink its inflated balance sheet of $4.5 trillion of government bonds.  While the markets may have an initial negative knee-jerk reaction, the gradual and measured unwinding of the Fed’s bond holdings will have a significant impact on the markets overall.  The current composition of the Fed is dovish and Fed officials do not want to take economic risks.

Question: How much does your forecast rely on the administration’s proposed tax reform and other pro-business agenda items being passed?  How much of it is already baked into the market?

Answer: My models do not incorporate any pro-growth legislation from Congress. My assumption for future stock price gains are not based on price-earnings expansion but rather based on earnings per share growth.  In my opinion there is a low likelihood of comprehensive tax reform being passed in the next year.  Specific tax cuts, for both individuals and corporations, are likely within the next six to nine months.

Question Housing has been resilient.  How is housing doing? How is it affecting the economy?

Answer: Underlying demand for housing is very strong while supply is and will continue to be constrained by limitations on land, labor, and building materials. House prices are rising at a 7% annual rate, and could increase by 5% per year over the next few years.

Question: What are your thoughts on active versus passive investing?

Answer: Right now many passive investors are doing well and performing better than active managers.  Passive investing is buying the index and everything in that index, which includes companies with strong fundamentals as well as those with poor fundamentals.  When the markets begin to reverse direction, companies with poor fundamentals will decline more rapidly and active managers who focus on fundamentals will have the advantage.