INSIGHTS

On January 29, 2018

AAM Viewpoints – Spiking the Porridge. Goldilocks Economy Gets Extra Innings.

Synchronized global economic growth is a reality and after nearly a decade of record-breaking monetary stimulus in the form of Quantitative Easing (QE), many of the world’s central banks are handing the reins of economic stimulus to fiscal measures. The tax law changes in the United States is a very good example of measures that governments will be taking to extend this expansion. The implications of the U.S. tax legislation are not fully appreciated by the markets. The stimulus provided by the tax reduction on businesses will be the foundation of manufacturing, job and capital expenditure growth for the United States in the future. Next comes infrastructure spending. The United States is currently leading the world in economic growth and we believe these actions are significant and will likely result in “extra innings” for this Goldilocks expansion. Fiscal stimulus has spiked Goldilocks’ porridge and we expect growth higher for longer.

President Ronald Regan once said that, “If you want more of something, subsidize it; if you want less of something, tax it.” For the past decade the United States has been saddled with a tax code that penalized business’ growth. After the financial crisis of 2008/2009, the U.S. government has been an impediment to growth as the regulatory and tax pendulum swung hard against industry at the same time that recession gripped the nation. Foreign countries were luring American companies to lower tax domiciles. It was the Federal Reserve (Fed) alone who acted to apply a record dose of monetary stimulus in the face of a gridlocked Washington. The monetary stimulus worked to produce one of the weakest recoveries in history. Washington finally has been able to re-tool the tax code, enabling businesses to compete on a global basis. Reduction of taxes will have an outsized result of restoring investment in American business by American business. The handoff of monetary stimulus to fiscal stimulus is a very good turn of events, continuing the U.S. economic expansion as well as global expansion.

We have high expectation for the economy in 2018. Our view of the foundational changes discussed here will likely produce a U.S. GDP growth of well over 3% this year. Earnings growth – which determine equity prices – are expected to grow by 12-15%. That is a big change that will support higher equity markets. However, remember that markets tend to price-in the future early. So, although we expect a great year for the economy, some of – or maybe much of – that growth is likely already priced into the markets. Do we think that the equity markets will continue the Bull Run? We do, but we would expect more muted results than the first few weeks of January have shown.

We hope for a meaningful correction, which we are pretty sure we will see. The question is “When?” The longer we go without a correction, the more severe that correction will be when it occurs. Corrections allow markets to build bases to go higher and are a very healthy part of a bull market. Corrections are inevitable. They always come – just like the day always follows the night. They shouldn’t be feared but they should be expected and respected.

The greatest worry that we hear expressed is that the equity markets are overvalued. It is true that equity valuations are at the high end of the range, but our expectation of higher earnings will support higher prices from here. We wonder if the real over valuation might be in the sovereign bond markets. While the global economy feasted on record low yields, record high bond prices, and record issuance, the next chapter of this book likely calls for higher yields and lower prices. Does this mean we are suggesting selling bonds? Not at all. Timing the market is a fool’s game and one that destroys long-term performance. We do think that the strategy for managing your bonds needs a change.

Global central banks have been overtly attempting to fan the economic flames of inflation, but with little success to date. They have monetized a record amount of debt (over $21 trillion) and now sit on a third of all tradable bonds. They bought the bonds without deference to the price paid or the yield realized. In Europe the European Central Bank (ECB) drove yields into negative territory which removes any economic incentive to own the asset. Central banks now find themselves in a place where they see sustainable economic growth and signs that their quest for inflation is within their reach. The U.S. Fed has ceased the purchase of bonds and Europe and Japan will soon find themselves in the same position. They desire to begin the process of deflating their balance sheets by either selling or running off the massive hoard of bonds. In short, the biggest buyer now becomes the biggest seller.

In “late innings” of an economic expansion it is normal to see increases in inflation and in interest rates. Central banks sorely want to normalize interest rates as cheap leverage leads can lead to bad ends. Higher interest rates, albeit good for those that receive it, can become more challenging for those who pay it. The U.S. government lives on borrowed money and is very sensitive to interest rate movement. Higher interest rates also cause the hoard of bonds owned by central banks to be worth less. From corporations to governments, higher interest rates mean that the costs of operations go up. Higher interest expense together with the need to finance higher deficits with debt can weaken the creditworthiness of governments, just like corporations.

Higher inflation rates also drive up the cost of labor and other input prices. We have seen the conclusion to a very long commodity bear market that ended in 2016. Commodities, generally, are rising in price as global demand spikes. History has shown that higher input prices and higher labor prices eat into profit margins and, if the intensity of the rise is high, can result in recession. This is the tightrope the Fed now walks. If this Fed is like others throughout history, they will leave rates too low for too long and allow the economy to run hot for some time to come.

What does the asset allocation playbook call for at this juncture? The first thing that we would point out is that there has not been a meaningful bear market in bonds for decades. We are due for one and we believe that since it has been so long since the last one, this one could be severe. We think that there are a number of reasons to expect higher rates, and few to expect lower ones. Rates on longer dated Treasuries are pressing higher and appear that they could break out over long-term resistance levels. Bond duration risk in the market has never been higher and the potential reward for taking that risk has never been lower. We live by the maxim, “Don’t fight the Fed.” The Fed is raising rates, don’t fight them. We believe investors should consider reducing duration risk, and reducing exposure to assets that suffer in higher rate environments like utilities and REITs (Real Estate Investment Trusts).

What we find unnerving is that there are few players in the financial markets that have ever navigated a bear market in bonds. The last secular bond bear market was from 1962 to 1982. Precious few advisors, traders and portfolio managers that are in the business today were in the business back then. Lack of skills in dealing with a secular change in what most believe are their “safe” assets will likely be costly for bond investors.

The late cycle playbook also calls for commodity prices to escalate higher. Right now, commodity prices – as a percentage of equity prices – are at their lowest level since 2007. The graph below shows just how cheap commodities are. Global economic growth translates into growing demand for commodities. We believe that a secular commodity bull market has begun and has many years to grow. Markets tied to commodity prices are in a position to grow as well. That is why we favor commodities that include energy, materials, grains and emerging market.

The handoff of monetary stimulus to fiscal stimulus should extend this economic cycle into what could become the longest in U.S. history. Although we expect a big expansion in U.S. corporate earnings, we also know that a lot of growth has already been priced into the equity markets. Bond markets may be the real problem child of 2018 as rates and inflation tend to manifest themselves in the later parts of the economic cycle. Curbing duration risk remains a focus for our strategy. Commodities, financials and consumer discretionary sectors are traditionally the winners in higher inflationary and interest rate environments. Global expansion favors emerging markets and developed markets in Europe and Asia. Fiscal stimulus has indeed “spiked the porridge.” The economic party appears to be gaining a second wind.

CRN: 2018-0109-6312 R