You Can't Have One Without the Other

In writing this blog, I have always tried to stay away from the mumbo jumbo of financial-market commentators and strategists. But talking about that mumbo jumbo, at least obliquely, has to be done once in a while. Today is one such day.

Crosscurrents in the global economy

Currently, the global economy and financial markets are caught in the crosscurrents of cyclical and secular drivers. On a cyclical basis, the global economy has bottomed out and is clearly accelerating. The impulse for this expansion is coming from virtually every economy—and the primary driver has been the significant stimulus that has been added to the world economy in the form of interest-rate cuts or quantitative easing (QE) by the European Central Bank (ECB), the People’s Bank of China (PBOC), and numerous other central banks over the past year. The U.S. Federal Reserve is probably the only exception since it hasn’t added any new easing initiatives at the margin. Nevertheless, even the U.S. economy is rebounding from its dollar-driven funk and is poised to bounce back smartly.

You don’t have to look very far to see the tangible evidence of that rebound in various economic indicators—from global Purchasing Managers Index (PMI) numbers and U.S. employment to signs of Chinese stabilization.

In other words, on a cyclical basis, everything is looking quite good.

But—and here the mumbo jumbo comes in—don’t confuse a cyclical rebound with a secular recovery. In other words, while we may see a temporary rebound in the global economy as a result of the interest-rate cuts, secular headwinds are still quite substantial. And most of those headwinds are blowing from overseas:

• Europe, while enjoying a cyclical bounce, still faces enormous challenges due to demographics and deleveraging;
• Emerging markets, including China but with the exception of India, are still in a slowing trend; and
• Structural challenges in Japan are virtually unsolvable in the current political economy of that country.

When the global rebound fizzles out

Simply stated, the gravitational pull of the secular forces will likely cause the cyclical bounce—however real and meaningful in the short to medium term—to be short-lived. You can’t have one without the other. The global economy will likely do well for the next few quarters, and then eventually start slowing down again.

The drivers of such a slowdown would probably include the following:

• Europe coming off a QE-driven bounce, as financial conditions are already tightening;
• A strengthening dollar, with the Fed back in play for this year; and
• A dollar-driven tightening of domestic monetary conditions in China, which are diminishing the effect of the PBOC’s policy easing.

This slowdown would be an exact repeat of the economic performance in the second half of last year. Unless and until some part of the global economy starts re-leveraging, you can’t have synchronized global growth with savings rates sustained at high levels. Those savings have to go somewhere, and they would begin to slow down the economy of wherever they go. This is precisely what happened to the U.S. and Chinese economies (because of China’s tacit currency peg to the dollar) over the last nine months, and that’s probably what is going to happen to the European economy over the next few quarters.

What investors should consider

So, after all is said and done, what are the investment implications?
I believe long-term investors should consider that interest rates will remain low for quite some time. It doesn’t mean we won’t see 2-year rates in the United States rise more than usual—but longer term rates should remain below 3% for quite some time.

In this context, we believe global equities would still outperform global bonds. The key point to remember is that on a global basis, top equity performers will likely rotate on a virtually semi-annual basis. U.S. equities were top performers until they gave way to Europe in the past six months, but we’ll probably go back to seeing U.S. equities outperform their European counterparts once again. However, since these short-term turns are so difficult to predict, a diversified global equity portfolio has been and remains our mantra for the time being.

In fixed income, credit is still our preferred sector of choice. And with the potential of modest divergence in economic performance between regions, we favor U.S. credit over European credit, loans over high yield bonds and limited-term munis over longer-term munis.

Yet these are all short-term tactical views in the context of larger sector allocations. And if you don’t change your portfolio much, I won’t hold it against you.

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