Typically in June we update our macroeconomic and capital market views from the previous year end. This year, we’ll also examine how five key market hot-button issues are beginning to evolve. While we struck a cautious tone at year end, a common thread running through many of our current views is that despite solid global earnings trends, the outlook has deteriorated from our glass-half-full stance in December 2017.
Living Dangerously, But Surviving
In what we titled A Year of Living Dangerously, we started by noting that “2018 could shape up to be a challenging year. As the economic expansion matures, investors may face difficult choices. Fiscal and monetary trends could collide with extended valuations and geopolitical risks to create market volatility that has been absent for several years.” Other than the reference to “extended valuations” (which we’ll come back to), this proved to be a more-than-fair summary of the first half of 2018 and we believe it’s a reasonable prognosis for the second half.
However, our words of caution were balanced against a very strong fundamental backdrop, characterized at the time by the nearly universal incantation of economists and strategists – “synchronized global growth.” Combining the two, our year-end outlook painted a picture of positive but limited growth prospects for risk assets like stocks and bonds, within an environment of greater overall volatility – assuming the global growth scenario continued to hold. But as we enter mid-year, there are signs that we may be on less solid footing than we thought.
Changes at the Margin
For investors, we believe the second half of 2018 may become a bit more difficult. While there have been no momentous changes in the hot-button issues, we see some deterioration in these stories to varying degrees, starting with the outlook for growth.
#1 - Synchronized Global Growth: Six months into the year, the global growth story is looking a little dinged up. While global real GDP for 2018–2019 remains in a still-respectable 3.5%–4.0% range, cracks in the synchronized global growth story are starting to appear. Eurozone metrics remain solidly in the “expansion” range, but the level of activity has slowed, with the Markit PMI Composite Index falling from 58.8 (fantastic) to 54.8 (solid). Similarly, after a noticeable improvement from the second half of 2016 through 2017, growth also appears to be downshifting in the UK, Japan, China, and emerging markets more broadly. Only in the US are the activity metrics still in an uptrend. With most major economies running ahead of their longer-run potential output (as constrained by productivity and labor force growth), the pace of growth was likely to slow eventually. However, most forecasters had penciled this in for 2019–2021, not 2018. In summary, global growth remains solid and therefore supportive, but it is neither as strong nor as synchronized as previously thought.
#2 – Central Bank Rate Increases: No one is suggesting yet that central bankers are going to rip the monetary punch bowl away from investors. However, in recent months, the policy narrative has been evolving. Federal Reserve Chair Powell seems somewhat more resolute about the US tightening path than his predecessors were. In Europe, while rate hikes from the European Central Bank (ECB) remain a mid-to-late 2019 story, the bank has confirmed its desire to taper its asset purchases to zero by year end, a process some had expected to slide into next year. Moreover, Mario Draghi noted that recent political and banking woes in Italy would not deter policymakers from the normalization process. Dissent at the Bank of England has Governor Carney on the verge of raising rates this summer in spite of potential fallout from Brexit negotiations. And even the Bank of Japan, nowhere near ready to normalize policy rates, is buying Japanese Government Bonds and equity ETFs below their target levels – a so-called “stealth tapering.” As we move further into 2018, the benign tightening1 envisioned by hopeful investors has now become somewhat less benign.
#3 – Rates and the Yield Curve: We have continually pushed back against the flattening yield curve2 panic, arguing that:
a) The curve wasn’t likely to invert3 in the immediate future.
b) There has historically been a meaningful and variable lag (6–24 months) between inversion and recession.
c) For technical reasons having to do with Quantitative Easing and excess reserves, bank funding costs are not rising nearly as fast as the short end would imply.
However, while this remains our view, the simple math of #1 and #2 above is giving us more anxiety today. With growth slowing a bit (#1), implying that longer rates may not rise much more in this cycle, and the Fed locked in on raising rates (#2), inversion of the 2-year/10-year US Treasury slope might come as early as the fourth quarter this year. An inverted yield curve occurs when short-term interest rates exceed long-term rates. Last December, our outlook for yields would have forecasted the inversion somewhere in mid-to-late 2019. We aren’t pushing the yield curve panic button yet, but the time horizon to inversion appears closer, so we’re watching it much more carefully.
#4 – Trade, Tariffs, and Politics: In recent months we have seen clear deterioration on the geopolitical front. In the US, trade policy has taken a darker turn than we expected. Tariff proposals, which had been viewed largely as rhetoric for bargaining purposes, have now become reality. Not surprisingly, our trading partners are retaliating and we already see early anecdotal evidence of business fallout and supply chain disruption. Our larger trade fear, but one we considered remote, was that trade tensions would spill over into the capital markets, affecting rates and currencies. (Recent actions by China’s Central Bank to manage the renminbi lower are one example of that starting to happen.)
Across the pond, with the March 2019 Brexit deadline looming, it seems increasingly unlikely that Prime Minister May can pull a rabbit out of her hat and avoid crashing out of the European Union. There is no risk of Italy exiting the Eurozone (at least anytime soon), but the populist coalition government of The League and Five-Star Movement creates larger headwinds for Italy’s budget and banking woes. In Germany, Angela Merkel’s coalition has been shaken, Turkey is moving closer to autocracy (while losing central bank independence) and China is stepping into the vacuum created when President Trump attacks US allies and retreats from multinational alliances.* None of these recent developments should be taken as pro-market.
[*We haven’t forgotten the goodwill generated by the Trump/Kim summit, but like most observers, we discount the meeting as a relatively empty event with little positive, market-moving substance.]
#5 – Inflation and Valuations: Now for some good news... While higher inflation remains a key risk, other than the US Producer Price Index there are few signs that inflation has turned materially higher in 2018. This is important, because of the direct line between price stability and how “benign” the global tightening cycle is likely to be. Moreover, inflation is stable, many asset classes are range bound in price terms, and earnings and cash flow growth are solid. As a result, valuations have shown meaningful improvement from mid-2018 vs. late 2017. Excluding banks and European stocks (an overlapping set), we still see few if any “cheap” asset classes. However, forward and trailing price/earnings (P/E) multiples have improved in virtually every region/country and credit spreads4 in the bond market have generally widened in spite of solid revenue and cash flow growth. Is the global bargain bin overflowing? No. But at the margin, investors are paying less today to buy those cash flow streams than they were last year. Asset valuations are somewhat more attractive today than last year.
Our outlook hasn’t changed significantly, but our call for caution is a bit louder given the modest deterioration we’ve seen in the variables noted above. For now, the global economy remains strong enough to support risk assets like stocks and the credit sectors of the bond market. It would be premature to get bearish, in our view. However, the clouds on the horizon have become a bit darker in recent months, so we reiterate that this late in the cycle, discretion is the better part of valor.
In US stocks, organic earnings growth (not driven by tax changes) should continue into 2019, supporting prices which we expect to migrate higher but with much more volatility. However, central bank policy and continued geopolitical risks make outsized gains unlikely. We believe non-US markets offer better value (cheaper prices), but US equities are likely to outpace them until something dents the tech sector or the US dollar’s appreciation cuts into earnings.
In fixed income, we think the upward migration of yields has made interest rate risk more tolerable. At the same time, credit spreads remain fairly tight in spite of some recent widening. This argues for bond portfolios that are more equally balanced between credit risk and term structure risk – investors aren’t getting paid to stick out their necks for either of these risks. Cash and cash equivalents, especially for US investors, are becoming a more viable investment option because their nominal yields are no longer swamped by inflation. And dry powder becomes more useful when volatility rises.
Finally, we believe investors would be wise not to give up on alternative, hedged, and de-correlated strategies this late in the cycle. Many of these strategies have lagged in the nine-year bull market, but as the clouds begin to darken, investors will be glad they held onto their umbrellas.
1 Tightening – the process of raising interest rates.
2 Yield curve – a curve that shows the relationship among bond yields across the maturity spectrum. A flattening curve means there is less difference in yield between short- and long-maturity bond yields.
3 Inverted yield curve – an interest rate environment where short-term interest rates are higher than long-term rates.
4 Credit spreads – the difference in yield between 10-year Treasuries and lower-rated bonds.
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