Curb Your Enthusiasm - Strategic Outlook: Q4/2021

Key Topics: Global Economic and Capital Market Outlook, Moral Hazard and Financial Imbalances of bond market manipulation, Inflationary Consequences of Extended Monetary and Fiscal Policy Stimulus, Federal Reserve, Monetary Normalization, Earnings Growth and Profit Margins, Fiscal Debt and Deficits, Infrastructure and Build Back Better legislation, Global TAA Forecasts: Bond and Equity Valuations, Geoeconomic Uncertainty and Risk.

Summary (See our Strategic Outlook:??www.StrategicCAPM.com/Commentary?)

We believe it has become a critical time to Curb Your Enthusiasm across global equity and bond markets. US equities became even more overvalued this year, particularly large-cap growth stocks, despite the strong earnings recovery expected. Higher inflation undermines already stretched bond valuations. We caution maturity extended and leveraged bond investors chasing yield, particularly asset owners adopting LDI and risk parity strategies.

US economic indicators like industrial production, retail sales, unemployment rates, consumer confidence, and housing all traced similar narrow V-shaped economic decline and recovery.?Whipsawing economic and earnings growth provide a growth illusion feeding irrational investor sentiment, but is unsustainable. Inflation undermines real income and earnings, thereby risking consequences akin to return limiting 1970s poor policy-driven stagflation.

Directed lockdowns of non-essential activities were not fundamental cyclical forces that reset a new economic cycle. The government-inflicted transitory recession (lockdowns, stay at home, social distancing, business closures, etc.) troughed last Spring 2020, so we are not at the beginning of a new cycle, but instead still expect late cycle behavior. Business closures, lost jobs, stalled education, and lost opportunities typically slow potential growth, but excessive stimulus provided an illusion of prosperity and fueled irrational investor sentiment. We expect the fiscal and monetary stimulus hangover will be difficult to manage. The acute moral hazard of financial imbalances is treacherous given more than a decade of monetary misbehavior, particularly for leveraged and extended maturity bond portfolios.

Misguided US monetary and fiscal policies triggered higher costs of labor, energy, food, basic resources, transportation, and housing, as well as services and imported goods. Increases in minimum wage, regulation, and tax rates can drive higher secular inflation, including regulation of energy and material production or distribution. US pricing power was absent due to the disruptive and disinflationary forces of the Fourth Industrial Revolution, boosting globalization, competition, and creative destruction, but these forces are subsiding. Non-transitory forces of inflation now triggered rising inflation expectations. We expect US CPI inflation over 6% in 2021 is becoming more difficult contain, but it should settle near 3.5% by the end of 2022.

Source: US Depart of Labor & Strategic Frontier Management

We have long suggested that interest rates are being artificially manipulated by central banks globally for the last decade–following recovery from the 2008 Financial Crisis. We seemed to be on the right track since 2016, at least until COVID-19 pandemic sucker punched us and politicians triggered a transitory global recession unlike any other. The recession ended in 2-3 months and we closed the output gap by early 2021. Accelerating QE Tapering should allow earlier US interest rate hikes than expected. We believe the Fed will begin raising interest rates next year.

Source: U.S. Federal Reserve and Strategic Frontier Management

The prolonged decoupling of equity and bond markets began well before the pandemic. If you wonder how soaring inflation can coexist with such low interest rates and speculative overvalued markets, look no further than explicit moral hazard of central banks manipulating the bond market for over a decade fueling financial imbalances. Negative US real interest rates cannot be sustained as economic growth has normalized and inflation surged beyond 6%, while boosting inflation expectations (4.8% in Univ. of Michigan Survey). Increasing US Treasury yields, which can easily more than double to 3-4%, will drive higher US interest burdens increasing fiscal deficits. Other international bond markets should follow suit soon after.

A critical global inflection point is observed in our global tactical equity forecasts, not observed in nearly two decades (Large Tech-Growth Bubble of 2000). S&P 500 earnings yield will deteriorate further if bond yields rise, as we expect. We’d avoid Emerging Market Equity that is exposed to China and Russia given geoeconomic and currency concerns, preferring global small-cap value versus US large-cap growth.

Real global economic growth and US margins should slow as excessive stimulus rolls off, including boosted entitlement income that pulled forward consumption. Productivity, global competitiveness and profit margins can suffer as reckless fiscal, tax, regulatory, energy, trade, and foreign policies take hold.

The US Government’s binge on monetary and fiscal stimulus eventually will end, accelerating bond losses and epic economic hangover. Policy stimulus that pulled forward consumption for an extended period reduced potential growth. Interest burden of soaring debt will increase fiscal deficit with rising rates. Monetary and fiscal Keynesianism can giveth easily, but always taketh away more when reversed, as pulled forward demand diminishes future growth. The fiscal and monetary cliff emerging could be breathtaking and why the Fed is fearful of the final act.

Moral hazard unwinding extended manipulation will be tricky and likely increase volatility. Risk of a global financial crisis is rising, as is potential for bond yields overshooting equilibrium as the yield curve steepens rapidly. Central banks have little capacity to respond as their credibility diminished. US Treasury debt from excessive stimulus now exceeds 128% of GDP with a projected fiscal deficit still in excess 10% of GDP.?Last quarter we published Strategic Insights: America’s Infrastructure Boondoggle, June 2021. What a shame to waste so much money on successive stimulus bills without considering the desire for an additional massive infrastructure boondoggle costing up to $4.5 trillion. Eventually, it was carved up into: $1.2 trillion American Jobs Plan, and $1.8 trillion Build Back Better bill that passed in the House, but is struggling in the Senate. The Penn Wharton Budget Model extended their analysis to also assume all spending provisions in the White House framework were permanent, except the clean energy tax credits, and calculated BBB would increase spending by $4.26 trillion, well beyond the $1.87 trillion headline—thereby increasing federal debt by $2.7 trillion over 10 years. President Biden repeatedly stated that BBB “reduces the deficit over the long-term” and is “fully paid for” despite every analysis to the contrary. He also suggests BBB and Infrastructure legislation will lower inflation—that is unlikely too.

Our global tactical equity model forecasts deteriorated further with declining equity valuations. Any further recovery in earnings will hardly be sufficient to justify such high S&P 500 index valuations, despite a strong global earnings recovery. US equities will struggle to return 8.8% annual return observed for the S&P 500 over the last 60 years with low dividend yield and likely P/E contraction. Our decade-long tactical overweight of global equities has declined to the lowest level since the turn of the century (1999), favoring short-term fixed income and cash, rather than bonds. We also favor global small-cap and US value tilts within equities, tilting toward developed non-US equities, but are concerned about Emerging Markets, particularly countries such as China and Russia. Maturing Emerging Markets will struggle with lower earnings margin and slower growth that continue to disappoint investors, with greater risk of currency devaluations—China is most concerning, but also coincides with our terrible tactical forecast for Hong Kong equities.

Our strategic allocation forecasts reflect similar valuation, inflation, and interest rate concerns of our Global Tactical Asset Allocation forecasts. We revised US potential real growth lower toward 2% this year. US and foreign bond markets remain overvalued with negative real yields. Cash or short-term and floating rate bonds are better cheap alternative investments than any other public or private capital market. Retirement savings and dismal pension funding will suffer if equities and bonds lag inflation, as we expect.

These and many other questions we tackle are covered in our quarterly?Strategic Insights?from Strategic Frontier Management.

See our full?Strategic Outlook?commentary:? www.StrategicCAPM.com/Commentary? or?Strategic Outlook Briefing?maintained at:?www.StrategicCAPM.com/topical)

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Strategic Outlook:?This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third party sources deemed to be reliable. We make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication, and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of this author, and future market movements may differ from expectations. Index performance or any index related data is provided for illustrative purposes only and is not indicative of the performance of any portfolio. Any performance shown herein is no guarantee of future results. Investment returns will fluctuate, and the value of holdings may be worth more or less than original cost. ? Strategic Frontier Management (www.StrategicCAPM.com). 2021. All rights reserved.