As we move through the first few days of 2018, we would like to take a moment to reflect on the year gone by and provide some thoughts on the 12 months ahead. We hope 2017 was a good one for you and yours, and we wish you a happy, healthy, and successful 2018.
2017 was a year of synchronized global growth coupled with continued accommodative global monetary policy. With a backdrop of dismissed political/geo-political uncertainty and diminishing volatility, asset returns across the board were impressive. Equity markets marched higher and high yield bonds posted solid returns. The yield on the benchmark 10-year U.S. Treasury remained largely unchanged for the year, as the yield curve flattened in dramatic fashion. Investor complacency took over as volatility in all asset classes collapsed. Meanwhile, the Federal Reserve stayed true to their message from a year ago delivering three interest rate hikes along with starting the process of reducing the size of their balance sheet (quantitative tightening) by decreasing the amount of principal reinvested each month.
On the fiscal side, the Trump administration managed to deliver on one of the cornerstones of his election promises – getting a tax bill done. In the short-run, we expect that the tax cuts will provide a modest boost to economic growth, but at the expense of an already dismal outlook for the U.S. deficit. The cuts are driven by a significant increase in deficit financing, so if substantially higher growth rates do not materialize as estimated (less than likely), then difficult political discussions will surely follow. Additionally, with wealth disparity continuing to swell and the increasing polarization of red/blue states due to the new limit on state tax deductions, this tax bill ensures that these conversations have little chance to turn towards moderation. Lastly, from a growth perspective, we are puzzled by the timing of this tax bill. Traditionally, these types of fiscal moves are saved for times of economic hardship instead of during periods of economic expansion. With the unemployment rate at 17-year lows and solid underlying momentum in the economy, it begs the question: what is the rationale for spending fiscal bullets now as opposed to saving them for a time when the economy is truly in need of fiscal stimulus?
We expect an uneventful leadership transition at the Federal Reserve. New FOMC Chairman Jerome Powell is a noted consensus builder who has never voted against the majority during his tenure on the Federal Reserve Board of Governors. We expect him to continue the FOMC’s message of gradual rate hikes in 2018 while allowing for flexibility (should incoming data warrant a change in policy stance). With that said, Chair Powell’s job will not be easy as turnover within the Committee brings new faces and new egos to deliberations. The deeper into the current hiking cycle, the higher the stakes and costs associated with any potential policy miscommunication will be.
Despite the Fed’s best efforts (three rate hikes and quantitative tightening), financial conditions continued easing in 2017. Equity markets and home prices increased, and corporate credit spreads tightened. Yields, aside from short maturities, have barely moved as term premium appears to be a thing of the past. Said differently, the tightening of monetary policy in 2017 has been more about removing accommodation rather than tightening financial conditions. This dynamic can’t, and won’t, last forever.
The Fed forecasts three more interest rate hikes in 2018, while the markets are priced for less. At this point, our tendency is to take the Fed at its word, understanding that a significant drop in economic activity or a large increase in inflation will cause the Fed to shift its course. However, we are less concerned about the absolute number of rates hikes and more focused on the point at which rate hikes switch from being a removal of accommodation to actual tightening. Once there is more clarity on the latter, we would expect to see a dramatically different reaction in financial markets than seen thus far in the current hiking cycle.
President Trump campaigned on a pro-growth platform promising tax cuts, infrastructure spending, and the rollback of Obamacare and overly burdensome regulations. While executive orders rolling back regulations seemed to flow pretty frequently from President Trump’s desk over the past year, there were no large legislative gains until the fourth quarter. Just days before Christmas, the new administration got its first victory, passing the Tax Cuts and Jobs Act. The bill was marketed as a tax cut for the middle class, but seems to provide the most benefits to companies and those that can take advantage of pass-through entities. Starting in 2018, most American families will see the government taking less out of each paycheck, but those cuts are temporary, and a subtle change to the inflation measure buried within the tax code will slowly erode individual gains before the cuts eventually sunset at the end of 2025. There will continue to be arguments over the scenarios in which middle class families pay less; however, there is no arguing that the spoils of this bill will go to the wealthy and corporations.
While the tax cuts look to be a short-term tailwind for the U.S. economy, the potential longer-run growth implications are less friendly. Most importantly, the bill increases the federal deficit by an estimated $1.5 trillion over 10-years. Legislators’ use of “Dynamic Scoring” to prove the bill’s worth is a red flag for potential suffocation of future long-term expansion. Using potential increased velocity of economic growth to pay for an outsized increase in deficits is pretty much a non-starter in most rational circles.
Secondarily, we are not convinced that companies will suddenly increase wages and hiring while engaging in new capital expenditure plans – a key component that the tax cut proponents hark upon. Frankly, if U.S. corporations had projects and investments that would materially and positively affect their bottom lines, a tax cut is not the propellant – they would have acted already!
Finally, the trillions of dollars held by U.S. companies in overseas subsidiaries only pertains to a relatively small number of firms and the technology sector represents the lion’s share. We are not convinced that big tech companies with newly repatriated cash is a stimulant for sustained, higher long-run growth.
What having more cash – either via a tax cut or repatriation – does allow companies to do is continue with their shareholder friendly activity. Firms like Apple that issued large bond deals to finance higher dividends and buybacks can now retire some of that debt early and tighten up their balance sheets. With that said, deleveraging in response to policy changes usually takes place over long periods of time and any changes will likely be on the margin and depend heavily on corporate expectations for Trump’s re-election.
With the tax bill passed, the administration will likely turn its attention to infrastructure spending and trade deals. We suspect that any movement on the infrastructure front will be difficult given current and expected future deficit levels. There is no arguing that American infrastructure is in need of attention, but given U.S. debt dynamics and the fact that brinkmanship remains the default political strategy in D.C., we are not placing high odds on the passage of a large infrastructure package for 2018. On the trade front, the administration has a clearer ability to more easily influence trade deals. We’ll be following the handling of NAFTA re-negotiations as a blue print for the new ‘America First’ stance on trade.
In our view, the probability of a recession in the next 12 months remains low. This is the 9th year of the current expansion (long in the tooth by any historical comparison), yet global growth looks robust and synchronized. All of the world’s top 45 economies grew in 2017 and are expected to do the same this year according the Organization for Economic Cooperation and Development (OECD). For much of the current expansion, the story has been one of the U.S. economy leading the global pack. That narrative has now shifted to one of global strength, which should help to prolong the current U.S. expansion.
Looking at leading economic indicators, the U.S. economy is on solid footing. Manufacturing and non-manufacturing surveys remain elevated and measures of both consumer and business confidence are at, or near, cycle highs. The labor market, our preferred gauge of underlying economic trends, remains solid with steady month-over-month job creation. The unemployment rate sits at 17-year lows and new unemployment claims are historically low. The only piece missing is growth in wages as the average worker continues to see their purchasing power erode year after year. It is worth noting that some of the year-over-year wage measures are being skewed somewhat lower as a result of structural changes.
Our long standing, accordion-like business cycle thesis remains intact. The unprecedented amount of monetary accommodation arising from the 2008 financial crisis stretched the typical business cycle from 4-6 years to an elongated 8-12. While the tax cuts are shrouded with uncertainty and only time will reveal the true unintended consequences, there are a few scenarios that we believe to be highly likely. The tax bill will help corporations the most, providing them the latitude for another round of financial engineering. This could propel stock markets even higher as their earnings ratios suddenly end up looking more attractive – even without top line growth. Secondly, the tax cuts should be a short-term consumption booster over the next year, maybe two. Lastly, the tax bill will spark a further polarization in U.S. politics as income inequality gaps grow wider, and Republicans use blunt swords to punish states that typically vote blue. None of these outcomes are beneficial to long-term growth and stability. In short, once this economic cycle ends, there is a probability of a deeper trough due to the end of year 2017 legislation than before.
We continue to be amazed by the lack of volatility across all asset classes. The market seems willing to shrug off any negative geopolitical news. Whether it is the threat of nuclear war with North Korea, mass shootings or terrorist bombings, the markets hardly react negatively anymore. When they do, it’s short-lived as both Brexit and Trump’s election inspired initial selloffs only to spur a rebound to fresh highs. The complacency that has penetrated all corners of the market leaves asset prices susceptible to an abrupt reversal. However, unlike in 2007 and 2008, there is no big leveraged housing-type bubble hanging precariously over investors’ heads. Sure, an event that had previously been shrugged off by market participants may spark the beginning of the down-trade, but most likely it is something no one anticipates, save for a few “seers” who will live off that call for the next decade.
Before diving into the weeds, let us be clear about how we view Bitcoin from an asset allocation perspective. We would never consider allocating any client capital to crypto currencies such as Bitcoin or funds that invest in the like. Digital currencies have yet to show fundamental value as an accepted medium of exchange for legitimate goods and services. With that said, just because we would never consider allocation capital to Bitcoin or other crypto currencies doesn’t mean the story isn’t interesting.
Bitcoin is an open sourced digital currency powered completely by its users. Transactions are anonymous and irreversible, helping to create a level of perceived security that has increased the popularity of the cryptocurrency. While the unregulated and decentralized characteristics of Bitcoin have contributed to its success, these have also become some of Bitcoin’s (and others) biggest weaknesses. For Bitcoin, the cost of energy and computing power to mine an additional coin is now close to $6,000/coin and must rise in accordance with the algorithm. The number of available Bitcoins is only 21 million. Together, these problems characterize Bitcoin as more similar to Beenie Babies than Benjamins. If that is not enough, the increasing number of hacks (not unlike bank robberies) have highlighted the lack of ability to act as a store value. There are no authorities to either protect against or assist in reclaiming stolen Bitcoins. Additionally, there is almost no chance of reversing fraudulent transactions to recover stolen coins. So much for deposit insurance.
Bitcoin and its brethren remain extremely risky, and bubble-like behavior should be enough to cause pause for any potential investor. Whether it was the South Sea Company, Dutch Tulip Mania, the Dot Coms, or the U.S. housing market last decade, Bitcoin’s chart looks pretty similar.
Digital currencies are in their infancy and platforms like Venmo, PayPal, and others have infinitely more penetration with consumers. We expect subsequent iterations to address some of the shortcomings which could increase the probability of digital currency acceptance. While the future of Bitcoin is unknown, the Blockchain technology behind the digital currency appears to have broader implications. While its notoriety came from the rise of Bitcoin, Blockchain is not a currency-only problem solver. At its core, Blockchain is a public ledger containing every transaction ever processed for the asset in question. This verifies the validity of every transaction. Although originally designed for Bitcoin, Blockchain technology has greater uses elsewhere, far beyond the murky, uncertain world of Bitcoin.
Within the financial markets, trades and settlements could become almost simultaneous through Blockchain, eliminating the need for intermediaries. Errors would be eliminated and security would be strengthened by using encryption technology rather than a standard username/password process. Smart contracts and stronger identity management are also potential applications. Blockchain can be programmed to automatically execute once certain conditions are met without a third party involved. Client verification can cross multiple markets and institutions, potentially reducing the duplication of customers’ due diligence requirements from increased regulations.
All of this is to say that while get-rich stories associated with Bitcoin dominate today’s headlines, the more interesting story to us is the potential long-run implications of the technology across industries.
After a selection process that was literally like none other, President Trump has officially nominated Jerome Powell to be the next Chair of the Federal Reserve. Mr. Powell, a lawyer by training, has been a member of the Board of Governors (BOG) of the Federal Reserve since 2012 and will ultimately be confirmed even if the Senate hearings get contentious (think rules based vs. discretionary monetary policy). Mr. Powell has proven himself to be a centrist, voting with the consensus at every policy meeting during his tenure on the BOG. As such, we expect a Jay Powell led Fed to remain patient, and continue down the path of gradual interest rate hikes.
Where he differs from Chair Yellen is on the regulatory front. We expect him to be more willing to relax financial regulations that have become overly burdensome. If regulation can be relaxed without jeopardizing the core principle of the financial reforms put in place after the 2008 financial crisis, we expect him to pursue such policies. Additionally, we are curious to learn if he will be marginally more sensitive to the role that ultralow interest rates have played in recent asset price inflation. A chair who is more in tune with growing financial imbalances would be a welcome shift from our perspective. Simply put, Mr. Powell’s likely course of action fits nicely with the current administration’s agenda and is largely a continuation of the Yellen/Bernanke Fed.
This nomination came as no surprise to investors as markets were little changed after the announcement and volatility fell (yes, it had room to fall further). Looking forward we expect the future path of interest rates to be little changed under a Powell Fed, thus equity markets can breathe a collective sigh of relief. We continue to believe that one of the biggest risks for equity markets is a rapid and aggressive tightening cycle. Without a dramatic shift in the inflation outlook we expect no such outcome with Powell at the helm. With that said, we have argued in previous editions that anecdotal evidence suggests inflation pressures are bubbling beneath the surface which begs the question, how far behind the curve is a Powell Fed willing to fall?
After weeks of trial balloons and market jitters, the most striking part of yesterday’s announcement is the general complacency that has penetrated every corner of financial markets. From a policy perspective, steady as she goes is usually a good thing as it means less uncertainty. However, in this situation, steady as she goes means mounting financial imbalances, a trend that is unsustainable. Eventually this docile financial environment will become unruly and intraday volatility will reign supreme. But pay no attention, that is business for another day. For now, all we can do is quote a famous American cult film, “Party on Wayne.”
It has been almost 100 years since the U.S. mainland witnessed a total solar eclipse. As we approach the August 21st phenomenon, towns and cities across America that are lucky enough to be in the “path of totality” are girding for the influx of eclipse watchers.
On that Monday in late August, the moon will completely block the sun, leaving viewers to admire the sun’s previously invisible (to the naked eye) sparkling corona. The path of totality slices diagonally across the U.S. from Oregon to South Carolina and suffices as a solid starting point for any model that tried to predict the outcome of the 2016 U.S. presidential election.
As excited Americans finalize their travels plans, this summer’s total solar eclipse is a reminder that while events, experiences, and outcomes can feel intensely unique and impactful, it is easy to misinterpret cause and effect. As we sift through the daily barrage of financial information and data, we too need to routinely step back, take a breath, and ask ourselves, are fundamentals and data changing prevailing market trends and sentiment or are investors backing into theories based on price movements?
Investment Solutions For Captives Just the other day, our Charleston office ordered special eclipse viewing glasses so everyone can look directly at the eclipse without damaging their retinas. Along that narrative, it feels to us that many investors must be looking at the current investment landscape similarly – viewing the markets with a special type of lense that blocks out any negatives and highlights the beauty of an always rising equity market. Alas, the reality is that after an almost decade long expansion, we have a few concerns when we examine today’s landscape. Namely, record levels of consumer debt, muted productivity, an aging population, underfunded pensions, and political uncertainty. Non-financial corporate debt is at record highs as leverage metrics have increased dramatically. Moreover, external factors such as Brexit and other potential geo-political events pose additional risks.
Additionally, investors have enjoyed years of excessively easy monetary policy, and the multiyear long grab for yield has multiple markets looking frothy, or in some cases, overvalued. This list should be long enough to cause even the most optimistic of investors pause – but that certainly is not the case today.
In this Market Perspective, we further examine current market dynamics and explore whether it is finally time to plan ahead for the next economic downturn?
Since the American Civil War, there have only been two economic expansions longer than the current one. For some, the duration of the current expansion alone is enough to spark concern. However, we caution against this view since imbalances and shocks are the greatest factors in spurring recessions, not length. Just as some people may believe that a total solar eclipse portends a negative life event, there are plenty who argue that since the economy has been growing for so long, a recession must be around the corner. Both opinions miss the point. In the case of eclipses foreshadowing a negative life event, the more likely explanation is a well-documented cognitive theory called confirmation bias. More specifically, the human brain associates two events, and then assigns some sort of causality between them. If one believes that a total solar eclipse is a precursor to something bad happening, then when their cat dies a month later, clearly the total solar eclipse was the triggering factor. The confirmation bias here is that business cycles have ends and therefore the duration of the cycle portends the end. Under the rules of logic, there is certainly something missing. When this business cycle ends it will go down as one of the longest on record, but it’s not going to end because it was too long.
So where are we in the business cycle? What is the state of the U.S. economy? Are there imbalances? Should we be worried about recession?
To start, looking at economic fundamentals and financial data, we do not think there is a high probability that the U.S. economy is in imminent danger of falling into recession over the next 12 months. To provide a framework, we list some key financial and economic indicators in the table below for three time periods: June 2006, June 2008, and June 2017. These dates represent the U.S. economy prior to the 2008 credit crisis, during the crisis, and the current environment.
At the moment, equity markets remain a source of wealth; the yield curve has flattened (but nowhere near inverting); the labor market is solid; and, gas is cheap. On the corporate front, both the manufacturing and non-manufacturing sectors are reporting growth. While the excitement over fiscal stimulus and tax reform promised after the 2016 election has turned to frustration and a bit of disappointment, the general tone on earnings calls continues to be cautiously optimistic. This is not exactly what we’d expect to be hearing from companies if their leaders were worried about the economy falling out of bed tomorrow. So if a recession is not around the corner, what part of the cycle are we in?
Given this profile, where is there value in commercial real estate? Lending directly to a well-seasoned property operator with a recognized niche can still be an interesting investment for a long-term investor. Borrowing rates are still within the lower end of the historical range and the relative value over other fixed income instruments remains. Most fixed income investors, however, are not equipped to own loans outright and cannot lock up their clients’ capital.
Clearly we passed the mid-point of the current economic expansion. U.S. auto sales peaked in December of 2016 at 18.29 million units before falling 10% and stabilizing during the first half of 2017. Additionally, the labor market has fully recovered from 2008, and we are four rate hikes into the first stage of the current monetary policy tightening cycle.
In summary, we’re definitely not at the beginning of the cycle, we’re past midway, but a recession is not imminent. This puts the current expansion around the 7th inning, with plenty of ballgame left. As the expansion continues to unfold we will continue to monitor labor market data closely, as we feel it has done the best job describing the true underlying momentum of the U.S. economy during this expansion.
As we have previously stated, one of our main theses about the current economic cycle is that it can be viewed in slow motion – extraordinary monetary policy accommodation has distorted the cycle to approximately double the historical normal length. Under this methodology, halfway through 2017 represents the 8th anniversary which points to a third to a quarter of the cycle left (i.e. 2019-2021 when the exhaustion finally tips the economy).
However, this analysis does not take into account certain factors particular to this expansion nor do external shocks feed into the model. How does one reconcile a still expanding economy with the laundry list of concerns that we highlighted earlier? The amount of debt in today’s system is frightening. Corporations have taken advantage of the low interest rate environment, refinanced, increased leverage, and showered shareholders with increasing payouts to both make them happy in a low yielding environment as well as make earnings growth look solid (even though it is superficial). Similarly, consumers have begun to lever up as total consumer debt, as a percent of gross domestic product, has reached fresh all-time highs with student loans becoming a serious hindrance to future growth.
Additionally, economies are always susceptible to negative growth shocks. China remains a source of considerable uncertainty and is playing an increasingly important role in the global economy. Thus, any unexpected negative news out of China will have bigger implications as it ripples through the rest of the world, as seen during the late summer of 2015. Meanwhile, geo-political shocks stemming from a Brexit breakdown, ISIS, North Korea or other such events could be equally detrimental to growth trends and are even harder to predict.
These risks and imbalances are real, potent, and should not be ignored even though investors currently see nothing through their eclipse glasses. This is evidenced by the sizeable drop in global asset volatility and a remarkable run of risk asset price gains without any meaningful pauses. Perhaps once those glasses are removed, the markets will become fixated on negative news, data, and/or events that typically have influence on investor sentiment.
The objective for us is to be able to recognize misplaced confirmation bias and see through the noise. In other words, while a market pullback is certainly in order, that does not mean it is the beginning of the end. This economic cycle is far from over, but it is essential to pay attention to the sign posts up ahead that will assist us in guiding our client portfolios through the remainder of this expansion and the next recessionary period. While August 21st represents the first total eclipse viewable from coast to coast since 1918, few realize that total solar eclipses occur fairly regularly over the rest of the globe. An increasingly connected global economy can both hinder and help the speed of localized economic cycles. As the U.S. enters a sensitive part of the business cycle, it is increasingly important to evaluate each emerging trend and new piece of market data in this global context. Being too narrowly focused and reactionary to each individual piece of incoming data can be detrimental to portfolios and performance over the long run.
Cognizant of today’s risks and imbalances, yet humble enough to know that unforeseen shocks can destroy even the best analysis, we maintain a defensive position within client portfolios. It is not time to pack up shop and insulate portfolios for the next economic downturn. However, given the current landscape, we feel it is prudent to dial back exposures. The current goal is to capture a good portion of the potential available remaining upside, while making sure that no harm is done should the cycle end sooner than expected or a Black Swan event derail global growth and markets.