A Few Things We’re Watching

August 01, 2017
By Patrick V. Masso, CFA

Getting a handle on the current state, and most likely future path, of the global economy can be a tall order.

The Federal Reserve Bank of St. Louis hosts one of the most well-respected central repositories of macroeconomic information. In fact, their economic research website contains nearly 500,000 different data sets from 87 different sources! Today, we delve into four data points we anticipate will be of heightened importance over the next several quarters.

First, we have a data series that tracks initial claims for unemployment insurance benefits. Think of it as a way to gauge the health of the U.S. job market. When times are tough and companies reduce their headcount to combat depressed demand for products, the claims for unemployment insurance jump higher. On the flipside, when companies increase staff to accommodate higher demand, the need for unemployment insurance fizzles.

The chart above depicts the historical behavior of initial claims for unemployment insurance. Notice the large spike in claims during the Great Recession (recessions are highlighted in gray) and the subsequent decline over the last several years. Judging by this measure, the U.S. job market is incredibly strong. The last time we saw claims for unemployment at these levels was in the mid-70’s! As the current business cycle transitions from mid to late stage, we will keep a close eye on this chart. A shift higher would tell us storm clouds are gathering and a recession may be on the horizon.

As the labor market tightens further, history tells us to expect a push higher in inflation metrics. The above data series shows the Consumer Price Index, which is a measure of the average monthly change in the price for goods and services. It is based on prices for food, clothing, shelter, fuel, transportation, utility fees, and sales taxes. A greater number of people employed typically translates into higher demand for these goods, thus pushing prices higher.

One of the most interesting economic trends of the last several months has been the ratcheting down of inflation from a 2.8% annual rate in February to 1.65% in June. A sustained decline in inflation could translate into less willingness by the Federal Reserve to raise short-term interest rates. This has an impact on the future returns on assets in your portfolios.

Globalization, or the increase in overseas business activity, has been a major driver of global economic activity the last few decades. Changes in foreign currency markets have become incrementally more important to the performance of U.S. companies (and their stocks) as U.S. corporations compete for sales in non-U.S. markets. Take a company like Caterpillar, which generated more than 50% of its 2016 sales outside the U.S. It might sell a piece of mining equipment to a Brazilian company in exchange for Brazilian Real (Brazil’s currency). Caterpillar would likely need to convert those Brazilian Reals back into U.S. Dollars to pay dividends, interest on bonds, and operating expenses. The exchange rate at which they will be able to make that conversion depends on the fluctuations of the currency markets.

Similar situations apply to many U.S. domiciled companies. In fact, over 30% of the S&P 500’s sales are generated in foreign countries. Currency movements are driven by a multitude of factors. Monitoring the path of the U.S. dollar versus other currencies is important because it translates into real dollars and cents for sales and earnings and, therefore, the stock performance differences between companies.

The high yield, or “junk bond”, market tends to perform strongly when the economy is chugging along and the risk of borrowers defaulting on loans is low. This has most recently been the case since the first quarter of 2016. In fact, high yield bonds have returned nearly 7% over the last 12 months, far outpacing the “safer” areas of the bond market.

Good times for this category, however, won’t last forever. We are attentively watching the behavior of high yield “spreads”. This is the additional amount of interest that compensates high yield bond investors for taking on a greater amount of default risk. Spreads are now sitting at historically “tight” (or low) levels. This doesn’t necessarily mean spreads will imminently vault substantially higher and hurt high yield bond prices (remember when rates increase, bond prices fall and vice versa). A sharp move higher will likely need a catalyst, such as the continuous decline in oil prices from 2014-2015 or a more broad-based decline in economic activity.

As always, we’re watching…and will take swift action when it is warranted!

Securities and insurance products are NOT deposits of Heartland Bank, are NOT FDIC insured, are NOT guaranteed by or obligations of the bank, and are subject to potential fluctuation in return and possible loss of principal.

Legal, Investment and Tax Notice: This information is not intended to be and should not be treated as legal advice or tax advice. Readers should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.