Economic and Financial Market Whiplash
Strategic Outlook: 4Q/2020 (Commentary Archive)
Full Commentary: Strategic Outlook: 4Q/2020 of Strategic Frontier Management
Key Topics: Global Economic and Capital Market Outlook, Coronavirus Impact, Operation Warp Speed, Earnings Growth and Profit Margins, Federal Reserve and Inflation, Monetary Normalization, Election 2020, Soaring Fiscal Debt, Equity Valuations, Global TAA forecasts, Sources of Uncertainty and Risk.
Economic conditions have been grim since March with millions of layoffs and businesses closing, many that will fail. Unprecedented global lockdown of nonessential businesses and activities, affecting travel, discretionary spending, entertainment, and investment strangled a thriving US economy. This economic recession is unlike any other given its transitory underpinnings of quarantine policy decisions, self-inflicted by government decision makers. Universal lockdowns initially seemed to make sense given uncertainties about the virus, but as we learned more about COVID-19, there were differences in how each county, state, or even nation needed to manage health and wellness, beyond just slowing infection. Without clear consensus among many experts grappling with so many unknowns, how can government leaders make reliable policy decisions balancing needs of all interests?
Worldwide lockdowns caused a rapid collapse in global economic activity and implemented without much time to evaluate alternative guidelines with regard to economic fallout or unintended consequences of social isolation. Broad lockdowns limited many outdoor and other activities that were resistant to transmitting infection. As lockdowns moderate, we expected economic growth to recover quickly, in contrast to typical cyclical recessions. Unemployed and displaced workers can be rehired elsewhere, but others will have to adapt to an evolving job market with new skill needs. Thus, macroeconomic effects should be limited, despite devastating effects for specific companies or industries. Empty storefronts and offices will be leased again and failed businesses will be replaced, as new business formation takes hold, and thereby create many new jobs.
The economic recovery is under way after the worst quarter of the post-World War II era. The clock on one of the longest business cycles recorded was finally reset with sequential declines in real GDP with the Q2 headline of the -31.4% annualized growth rate (-8.9% Q/Q). Not surprisingly given the monthly data, real GDP rose 33.1% in Q3 with IPD inflation up 3.6%, so we now expect real growth to decline about -3.0% in 2020. Below we summarize our latest headline forecasts. Change in retail sales over the last year increased 8.2%, while construction (2.5%) and business sales (-0.2%) are flat. After Q3 real GDP of 33.1%, nominal GDP is -2.7% year-to-date, so neither additional spending or monetary stimulus is needed. It further blunts the notion that the Administration mismanaged the economy, particularly relative to any other country.
The last six months have been a challenging time for households, businesses and investors worldwide. We’ve all been affected economically, emotionally, physically, or socially by the global COVID-19 pandemic. Economic lockdowns of businesses and other activities led to rapid a collapse in the global economy. Social distancing rules were implemented too quickly to evaluate alternatives or the cost to the economy and society. The global economic damage will take time to overcome, but capital markets often discount future recoveries, seemingly disjointed from current economic conditions—this is not surprising to us, nor that equities lead turning points.
Key to our updated forecasts in Fear Itself of Geoeconomic Panic on March 16th was the notion of transitory “V-shaped” economic decline and recovery. Directed lockdowns by state and local governments can reverse much quicker than correcting natural imbalances, for example observed during the Global Financial Crisis. The New Normal playbook proved woefully misguided. The tactical opportunity to at least rebalance, if not overweight equities was missed by many, worse for those that reduced equity exposure during March. Why is the stock market so far ahead discounting a strong economic rebound? Equities and fixed income have marched to different time horizons—greater uncertainty of a more distant outlook results in greater volatility for equities.
March 23rd was a turning point for US equity markets, ahead of the summer rebound in the economy. We have observed a classic Main Street vs. Wall Street Whiplash. Unlike disorderly natural causes of most other recessions and financial crises, the economic dislocations were transitional. Once relaxed, a rapid “V-shaped” equity market and economic recovery took many by surprise. US large-cap growth companies led the way, but cyclical value and smaller cap stocks should catch up. Companies that facilitated work-from-home or internet commerce soared, beyond those deemed essential businesses, including grocery stores, pharmacies, emergency services, health services, home improvement, ride hailing, utilities, financial services, Amazon, and Wal*Mart.
This was the first recession that household income actually increased given government stimulus checks, plus unemployment insurance benefits, which replaced up to or more than 100% of wages for many households. This will wash out as the supplemental income program winds down, but higher wages are likely is to support higher inflation.
Balanced 60/40 strategic asset allocations may need some tuning (i.e., shorter maturity, less overvalued large-cap growth), but investment managers of alternative products suggesting the balanced portfolio are dying or dead begs the question what is the alternative? How can alternative products exceed return of public market asset class combinations, off which they’re priced and to which they are correlated? There is no alternative asset allocation that has beaten a global balanced strategy on a risk-adjusted basis, certainly net of all fees and costs. Even if future returns to equities and bonds are likely to be lower, so will likely returns of all alternative strategies.
Global tactical return forecasts offer objective guidance in challenging periods such as this. Global equity returns should far exceed expected negative government bond returns over the next 12-18 months. Upside-down performance of risk factors, such as value and small-cap premiums, reached new extremes, after persisting longer than ever observed. We’ve seen it before in 1998-2001 (Tech bubble) and 2007 (Quant Quake), but never has value underperformance turned the 10/20/30-year risk factor premium negative. The reversal in small-cap and value from 2002-2005 was equally breathtaking. Our value-growth model remained thankfully neutral last year, but value and small-cap could reassert leadership soon. However, it may take rising interest rates and inflation to do so. Small-cap equities and fixed income credit tilts are preferred.
Source: Strategic Frontier Management
Global bond yields should rise, particularly as the US yield curve steepens, central bank holds begin to run-off again (refunding supply), and bond liquidity tightens. Importantly, we expect a negative real return for 10-year Treasuries over the next five years that could undermine balanced portfolio returns. Increasing debt imbalances and liquidity concerns could exacerbate correction of overvalued global bonds, as normalization continues. Credit spreads also may tend to normalize as Investors reduce portfolio duration and risk, although default rates shouldn't change much, but increasing imbalances and liquidity concerns could exacerbate a correction. Explicit moral hazard results from manipulating bond markets and keeps yield curves flatter than conditions would dictate--normalizing monetary policy requires raising interest rates and reducing Fed bond holdings, which will drive up bond yields and interest cost of our extended federal debt. A global bond correction after a decade of manipulation could trigger the next financial crisis.
Although equity markets rebounded (S&P500: 5.6% YTD-Sept 30), US 10yr Treasury yields remain below 1%. US real interest rates across the yield curve are negative, as Treasuries seem unresponsive to normalizing growth and inflation. US Treasury continues to purchase bonds at the market, limiting higher yields, but eventually investors must demand higher yield to compensate for interest rate risk, if not concern about the US spiraling debt burden. We think government bond returns will struggle to earn a positive real return over the next 5-10 years after a decade-long market manipulation by central banks.
Thus, we recommend favoring shorter maturity fixed income or variable floating rate debt. Short-term bond funds with higher credit exposure enjoy higher yield without much interest rate risk, particularly as credit spreads have widened. We don’t expect much volatility in the US dollar. We are overweight cash, which is the only true safe haven now for investors—not gold or bitcoin, and certainly not commodities. Money market funds tend to still to have high fees—but getting little more than 0.1% at a bank is about as good as it gets.
Our Global Tactical Asset Allocation models have entered middle age, turning 30 years old this quarter. They have grappled with a wide range of valuation and economic conditions over the last three decades of nurturing them. Our tactical discipline forecasts global equity, bond, risk factor, and currency return across 15 countries (83% of All Country World capitalization) with an 18-24-month horizon. Our global tactical forecasts suggest global equities remain compelling and U.S. equity returns (S&P 500: 3400) should exceed bonds by a wide margin over the next year.
Election 2020 has consequences for US potential growth, global competitive advantage, inflation, profit margins, education, opportunity, liberty, freedom, and taxes driven by the balance of power. The respective platforms couldn’t be more dissimilar. We are concerned about probability of a Blue Wave, although status quo gridlock seems more likely to us. Reversing tax, trade, energy, and regulatory reforms could slow potential growth, reduce margins, limit earnings growth, and stall economic recovery. Pensions and retirement 401Ks hang in the balance with their dependency on equites. Spending more than we can afford on government programs won’t make it OK, and economic conditions suggest we don't need it. Soaring federal, state and local debt, burdens future generations and limits crisis flexibility.
Strategic Frontier Management, LLC is a California Registered Investment Advisor (RIA) providing Global Tactical and Strategic Asset Allocation solutions, as well as investment strategy consulting for asset owners and their investment advisors.
Disclaimer: 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 cost. ? Strategic Frontier Management (www.StrategicCAPM.com) 2020. All rights reserved.