US Resilience & Monetary Dependency
Summary Strategic Outlook – 4Q/2018 (Link to see full commentary)
Topics: Global asset allocation, equity valuations, resilient US economy, potential growth, monetary dependency and interest rates, trade, midterms, and sources of market risks
This quarter we focus on the causes and consequences of America’s Kevlar Resilience in a rapidly changing world. Higher potential growth is adapting to changes in fiscal, regulatory, and now trade policy reforms. Already high US profit margins have continued to climb. Increasing earnings and economic growth forecasts reflect increased visibility into 2020 and low probability of US recession for the foreseeable future.
Investors continue to face a tug-of-war between stronger US economic and earnings growth versus higher inflation, rising interest rates, and policy uncertainty. Fiscal and regulatory reforms enhanced potential growth and competitive advantage, but growth in other countries is disappointing. A Global New Order in US Trade Policy will boost export growth further with new trade agreements. However, Monetary Dependency has unnerved investors, concerned about even higher interest rates. Other countries continue to manipulate their interest rates and currencies for little benefit, yet there are indications some may follow suit on fiscal reforms. In spite of many uncertainties, we closed within 1% of our S&P 500 year-end target of 2950 on Sept. 26th.
US economic growth has accelerated, as others languished this year. Boosting America’s potential growth from 2 to 3% reflects increased economic efficiency and global competitiveness. Recurring secular benefits from tax and regulatory reform are rooted in changing incentivized behaviors persisting for decades. Productivity increases with business investment, yielding lasting competitive advantages, which should encourage other governments or even states to mimic reforms.
Extended explicit manipulation of interest rates and currencies can have adverse consequences. Recent spikes in volatility seem to reflect increasing Monetary Dependency. Central banks’ extended use of unconventional monetary policies with symmetric inflation targeting risk explicit moral hazard. Shifting abnormal beliefs has affected cognitive behavior of global investors, lenders and borrowers. Be wary of risks, but don’t exaggerate their importance.
We don’t expect the Federal Reserve to waver from hiking interest rates by ?% every quarter and reducing bond holdings. Tightening monetary policy should continue until interest rates reach 3.5%, or evidence of a likely recession emerges. Other countries are following suit, although not as consistently or aggressively. Rising global rates might surprise investors in 2019.
Rising Treasury yields caused equities to stumble repeatedly, but likelihood of a global bond correction is an increasing portfolio risk given a flat yield curve, overvalued bond market, tight credit spreads, and declining liquidity. If Treasury yields rise another 1% or more next year, interest rate sensitive exposures and safe havens, including high dividend yield, low volatility and gold, should continue underperforming. Gold, commodities, and cryptocurrencies should be avoided, as well as underweighting US bonds.
? New US trade policy imposed targeted tariffs for negotiating leverage that seeks to reduce trade barriers, although it also increased fears of a global trade war. Concern about adverse impact on global growth and inflation impact manifest as market volatility, but we don’t expect tactical trade tariffs to persist for an extended period. Our recent op-ed in The Hill explains how this New World Order in Trade can reduce the US trade deficit with higher export growth, thereby boosting potential growth. Limiting trade barriers should promote free and fairer trade globally. Real progress is evident already with NAFTA, Korea, Japan, and Europe (both EU & UK).
Equity valuations often correct when interest rates rise too swiftly, but the S&P500 is not extended. Economically driven yield increases in overvalued Treasuries yields will require investors to adjust their expectations about normalization. We expect quarterly rate hikes or 1% per year and $600B reduction in bond holdings to continue through 2019. The Federal Reserve is under new management, so policy decisions should respond to the economy.
Our Global Tactical Asset Allocation return forecasts still suggest favoring global equities versus US bonds over the next year. We suggest a moderate tilt toward small-cap and non-US equities. Hong Kong particularly stands out. Our US equity forecast remains positive, despite strong equity returns, rising bond yields, and strong US dollar. Price/Earnings improve if earnings growth exceeds equity returns—high profit margins with increasing revenue growth yield earnings growth that supports further upside.
The greatest risk to global financial markets could be an imbalance in excess supply of global debt, including overvalued government bonds. A correction in global bonds after years of market manipulation is a more likely trigger of a financial crisis, rather than housing, equity valuations or government policy mistakes. Japan, and a few Eurozone countries, particularly Italy, are of most concern. Japan has resorted to buying equity ETFs, which is treacherous and an unnecessary risk to taxpayers. Spiraling fiscal deficits, plus unsustainable debt, low interest rates, marginal potential growth, and weak currency begs for multiple credit downgrades. Financing costs would soar if investors lost confidence in government’s ability to repay its debt.
Strategic Outlook: Global Investment Strategy & Capital Market Outlook briefing is available on our website at: www.StrategicCAPM.com/topical
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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 original cost. ? Strategic Frontier Management (www.StrategicCAPM.com). 2018. All rights reserved.