Under a Full Head of Steam: Winter 2018 Commentary

“When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up.” Ray Dalio, successful fund manager

The equity markets and the world’s economies enter 2018 with a lot of momentum. As investors, we have to consider whether climbing stock prices and expanding GDP will continue, slow down or reverse their fortunes. Over the short term, it seems likely that inertia and tax cuts will keep economic growth healthy. The stock market’s progress seems less certain (doesn’t it always?) but earnings on the S&P 500 seem set to continue their winning ways, providing some support for a fully priced market. Truly good times. The simple principles enunciated by Ray Dalio (above) provide a good framework to discuss the new year’s possibilities.

As always there are concerns, and for a full airing of those we start with the Fed. Now under new leadership, we expect the central bank to continue its policy of ratcheting up short term rates and selling bonds as it reverses the extraordinary stimulus it administered in the wake of the financial crisis. The members of the Open Market Committee must negotiate a narrowing, safe middle path between strangling growth with tighter financial conditions on one hand or moving too slowly, which may let the long dormant threat of inflation rise up, triggering a sell-off in stocks and corporate bonds.

We believe inflation may well tick up during the next year, leading to higher rates (and lower prices) in longer dated bonds. As we end December, the 10 year Treasury Bond has edged up in yield to 2.4%, right around where it started 2017, but higher than just a few weeks ago. Inflation readings consistently above 2% could push 10 year rates to 2.6% to 2.9%. Inflation expectations are modest. If inflation breaks above its trend, then increased volatility is in the cards for stocks and bonds in 2018.

Increased volatility is to be expected after what has proven to be the calmest year in decades. Surging profits and news of accelerating growth look to be the predominant influences as we start the new year. Later this year, interest rates and Fed policy may have more to say. Potential wild card risks are present in North Korea, the Arabian Peninsula and the Italian elections. As always, we believe a portfolio diversified among profit sensitive stocks, rate sensitive bonds and inflation sensitive assets provides the best platform to negotiate uncertain, fast moving seas.

We are grateful for the continued trust you have placed in Altavista and the relationships we have with each of you. Stay warm with the winter weather and we look forward to meeting with you soon.

The Altavista Investment Team – Winter 2018