Myths That Conceal Reality
Strategic Outlook: 3Q/2019 of Strategic Frontier Management
Key Topics: Global Growth, Earnings Growth and Profit Margins, Secular Challenges of Emerging Markets, CPI vs. PCE inflation, Monetary Normalization, FOMC Forecasts, New Order in Global Trade, Household Net Worth and Retirement Savings, Equity Valuations, Global Tactical Asset Allocation, Sources of Uncertainty and Risk.
We have often written about Myths That Conceal Reality, hoping to highlight behavioral biases and what we believe to be misguided investment or economic beliefs. A guiding principle in our forecasting approach developed over three decades is to rationalize how economics and finance logically governs market and econometric relationships. This has become prevalent in discussion of the New Order in Global Trade and global transition from Synchronized Recovery to Asynchronous Expansion in 2012. Normalization is required to unwind low interest rates and reduce holdings of the Federal Reserve. Lower interest rates won’t increase growth if long-term financing rates can’t decline much more or without much demand to pull forward anymore. The Fed need not focus so much on Mythical global growth concerns given US exports were just 9-12% of GDP over the last 30 years. Mythical concern about low inflation expectations conceal the consequence of decade-long forward guidance, rather than a dysfunctional economy needing monetary support. We resurrected various charts and historical data to support our claim that there are unusual forces in play, but it need not be different this time.
US economic and earnings growth accelerated over the last two years, particularly after tax and regulatory reforms. US potential growth has risen from below 2% to over 2.70% with increasing global competitiveness. Other countries have languished, including Europe, Japan and China. Global uncertainty regarding fiscal, trade, and monetary policies can undermine fragile investor and business sentiment, but central banks should focus on real domestic economic conditions.
US economic growth settled into a higher potential growth range of 2.5-3.0% in the last year, although geopolitical challenges have undermined investor and business sentiment.
After a little patience to work through trade disputes, US business confidence, investment, and hiring should accelerate, reinforced by increased US potential growth realized through higher net exports. Developed nations also generally will benefit from US efforts to do what WTO couldn’t or was unwilling to do. Meanwhile, the post-war terms of trade support by the US for the benefit of developing economies will decline, and this will reduce the secular growth advantage enjoyed by emerging markets. This reinforces our case for China's decline from 6% potential growth toward 4% by 2025.
We continue believing a more typical Asynchronous Global Expansion describes the current regime. In this context, risk-on/risk-off is a silly notion, too often confused with increased volatility-of-volatility that reflects more fragile sentiment we’ve highlighted. Divergent monetary and fiscal policies cause cyclical economic differences globally. Asynchronous policies yield greater international diversification, not just among equity markets, but currencies, interest rates, earnings estimates, and economic variables.
Monetary manipulation failed to boost inflation as hoped, yet financial imbalances increased. US inflation can revert toward 3% with rising wage and housing costs, although the Fed’s long-run forecasts for inflation and interest rates declined since 2013. Adoption of the PCE price index also presumes ?% higher real interest rates. Normalizing inflation and growth expectations should drive 10-yr Treasury yields toward 5%, despite global relativism of $13T in bonds yielding 0% or less.
US interest rates were expected to rise over 3% a year ago, yet the 4Q/2018 correction in equities, ongoing trade disputes, and US yield curve flattening has encouraged adoption of recession forecasts. The Federal Reserve Open Market Committee (FOMC) now expects interest rates to peak at a lower r* or equilibrium policy rate of 2?% vs. r* > 4% just a few years ago. Pursuing rate cuts for “insurance” against global weakness or trade tension is inconsistent with US economic conditions.
We believe that the Federal Reserve is (again) LOSING CREDIBILITY AND ITS NERVE as it cut rates by ?% and cut short its reduction in bond holdings accumulated during an extended unconventional program of quantitative easing. This decision is more likely than not to have to be reversed given: 1. Recent better than expected economic data since June's meeting and versus Dec. 2018, 2. FOMC's assessment that economic performance is reasonably good and the FOMC's forecast outlook is also good, 3. Continuing price stability (see attached discussion on price stability mandate, PCE vs. CPI, and symmetric inflation targeting), 4. Full employment, if not better, and 5. Good corporate earnings and resilient profit margins. This decision seems to conflict with the need for rules-based consistency, process discipline, domestic focus (weakening international growth), and particularly it's claim that is remains "data dependent", in the shadow of a split decision with an unprecedented two dissenting votes that agreed with our assessment. Eventual need to reverse this decision is likely to result in yet another tumultuous market tantrum, when consensus gets unexpectedly surprised, and just the kind of market destabilizing policy volatility the Fed seeks to avoid.
We are surprised Treasury yields declined this year, and seems peculiar given US economic conditions. A flattening yield curve appears to be a function of unusual exogenous forces that bias unrealistic rate cut probabilities to over 90%. Rate cuts of ?-?% are now discounted for 2019, plus another ?% cut in 2020, but low inflation is not sufficient, nor warrants maintaining such stimulative monetary policy. Price stability seeks a stable level of prices to sustain the value of money, rather than a Myth that conceals reality implying a stable inflation rate target, even a misguided symmetric target. We believe monetary normalization should continue, unless or until evidence of a US recession emerges.
We expect forces inducing our constructive secular disinflation thesis to begin moderating finally after more than a decade, although our work on Global Future Themes supports still strong potential growth and productivity. Better understanding of secular disinflation might otherwise have limited adjustment of inflation expectations, rather than assuming disinflation was a symptom of weak demand. Central banks should abandon symmetric inflation targeting and it is a fools’ errand to attempt increasing inflation.
Our Global Tactical Asset Allocation return forecasts suggest global equities remain compelling and U.S. equity returns should significantly exceed bonds. We favor a tilt toward small-cap and modest bias toward value. S&P 500 valuations remain constructive with at least 6% earnings growth, sufficient to yield 8-10% US equity return in 2019. Avoid safe havens and rate sensitive exposures, and underweight global bonds.
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) 2019. All rights reserved.