FOURTH QUARTER ECONOMIC OUTLOOK
October 4, 2018
U.S. & World Economy
According to noted top economist El-Erian, the current trade wars represent “the journey, not the destination.” He goes on to say that after all of the noise and mess, the U.S. will have better trade agreements but there won’t be any fundamental change in the world trading system. In the meantime, our world economy has broken into two halves: the U.S. markets where the GDP is growing, the Fed is weaning off being “accommodative,” there are gains in the U.S. stock market and consumer confidence, and interest rates are rising – vs. the rest of the world, which is still stuck in sub-par growth with valuations mostly still below year 2007’s peak levels. Trade wars have only added to this disparity, where so far, the U.S. is “winning.”
So, how long will this last and when will the trend reverse? My forecast is 4 – 6 more quarters until the “Trump bump” is fully absorbed into the world economy. Economic and stock market expansions usually end when an excess in a particular market turns into a “bubble” and bursts. For example, in the 2000 – 2001 recession it was the dot.com & telecom bubble, and in 2008 – 2009 it was the housing bubble. This current cycle might end with a corporate bond bubble bursting. After years of ultra-low interest rates, large companies have loaded up with cheap debt. Even with relatively low interest rates, corporate interest expense has soared to a record level. With the economy firing on all cylinders, demand for debt should now be surging, but borrowing is down 14.6% from last year (according to Barron’s). This reluctance to go deeper into debt shows how low the pain threshold is to higher interest rates. Further, the size of the market of the lowest rated tier of bonds just above junk bonds (investment grade BBB) has tripled and is now the largest segment of corporate bonds. But debt has to be paid back or refinanced. Higher interest rates make this painful and could easily play a part in ending this economic expansion, particularly as the world’s central banks stop pumping $500 billion per month into the global financial system in 2019.
We are watching this and other economic indicators carefully, as markets usually respond to economic changes months in advance. Due to the long bull market, we remain very diversified and cautious.
Q3 marked an important milestone for the long-running bull market: On September 30th this bull market (as measured by the S&P 500 Index) extended its run to 3,493 calendar days (according to CNBC), becoming the lengthiest bull market in history, or at least since WWII. While we may celebrate this milestone, let’s take a moment to define and review the contributing factors.
A bull market is generally measured from the lowest point in a cycle to its peak. The peak can only be defined in hindsight, when the market has declined by at least 20% from its prior peak. That decline is widely considered to be a bear market.
To put it into context, the S&P 500 Index bottomed on March 9, 2009 at 676.53 (data provided by St. Louis Federal Reserve). Consequently, late 2008 and 2009 were bleak times for investors. Brought on by a financial crisis, the economy slid into a deep recession. Companies were quick to jettison employees and corporate profits fell sharply. But as we’ve observed time and time again, stocks eventually found a bottom, then a new bull market emerged, and the economy turned back around. Few could have predicted the current cycle (since 2009) would run as long as it has – or for that matter, run up as high as it has.
While not the best performing, the current run has advanced 329%, as Table 1 shows below.
Table 1: Longest Running Bull Markets Since WWII–S&P 500 Index Performance
Financial turmoil in Europe, the U.K.’s Brexit vote, the collapse in oil prices, worries about China’s economy, and the downgrade of U.S. debt in 2011 were just some of the headwinds that surfaced to create short-term volatility. These elements temporarily interrupted the bull market or, at a minimum, created concerns over the last decade.
When headwinds have failed to throw the U.S. economy into a recession, the focus has shifted back to positive economic fundamentals, and bull markets have prevailed.
Historically, bull markets have always triumphed over the longer term – eventually. Those who have bet on a long-term slide in stocks have been sorely disappointed. This is because short downturns in the economy (aka recessions) are followed by economic expansions that run much longer than recessions. Over time, in these instances the economy’s value has risen – and this has been the case for over 200 years. If we open our history books, the Dow Jones Industrial Average was below 100 in 1915. Today, it’s above 26,000.
The economy may or may not be larger next year, but history tells us it will be larger 10 or 20 years from today. Continuing along that same path, the major market averages are likely to follow a similar trajectory over a long period.
As we read above, our long bull market continues and our concerns about its life expectancy grow.
While Emerging Market equities outperformed U.S. equities by 45% last year, this year returns have flipped to U.S. equities outperforming Emerging Markets almost 2:1. Other than U.S. Equities, we are experiencing remarkably low returns from all other liquid investment sectors. Our direct investment real estate investments are outperforming liquid investments thanks to cash flow and a couple of year-to-date long-term capital gains.
This is what we know: The U.S. economy is overheating and it is pushing inflation and wages higher. Tax law changes have benefited U.S. companies, particularly small cap companies, and many large cap companies have supported share prices via stock repurchases made with repatriated cash. With the Fed exiting the bond market support, we are seeing the supply of Treasuries exploding. Hedging costs for foreign buyers of U.S. Treasuries have risen significantly making them less attractive. We are at the beginning of the bond bear market cycle which may last through the next recession.
During Q3 in our liquid investment models, we trimmed positions and took nice profits on two REITs that had outgrown their model allocation and had shown outsized volatility in this rate environment after outsized returns last year. We sold out of under-performing Alternatives funds when their risk/reward opportunity increased. We waited for long-term capital gain time-frames to arrive (12 months) to switch out of a Global Small Cap ex-U.S. fund to a Global Small Cap fund which includes the U.S. Very short-term bonds and floating rate funds are likely to be our parking spot for cash in transition.
For our specialty illiquid investments, in Q3 we saw a successful sale of a hotel partnership in Colorado, saw a small return of capital as expected on a multi-asset hotel partnership and a multi-family fund partnership, and lastly we learned of another successful exit from a retail center is highly likely in the beginning of Q4. Our Investment Committee voted to increase model exposure to the longevity contract (life insurance policies) hedge fund and we continue to search for low correlation and investments that gain value in rising rate and inflationary environments.
In our minds, a 60/40 investment portfolio brings significant risks with an overextended U.S. stock market rally and a bear market in bonds. Our experience tells us and our duty to clients dictates that we invest in diversified portfolios that are focused on tax efficiency and asset protection.
Global equities in Q3 were mostly positive except for a few international securities. The U.S. equity market is entering a late cycle and most of the securities have posted very strong returns based on the momentum of the markets, good earnings reports, and the trade wars. However, we are concerned that U.S. equities are getting expensive relative to historical averages. Although we made a shift to change back to our strategic weights of equal weight to U.S. equities from previous underweight tactical weights, we are aware and cautiously watching the rally to slow down or turn negative. Overall, this year has not been a good environment for international equities due to a strengthening U.S. dollar. However, when we evaluate stocks based on fundamental factors and opportunities based on valuation of stocks, emerging markets present very value-conscious investment opportunities.
As you can see in the chart below, Global Real Asset class had mixed results for the quarter. Some of the interest rate sensitive securities such as REITs were negative. Gold was negative mainly due to U.S. dollar appreciation. Commodities took a negative turn due to a slow rate of growth in the global economy however, we got a good boost on Agriculture Stocks. The Global Fixed Income asset class will be challenging to navigate in the future due to rising interest rates. The market favored lower credits (higher risk) such as High Yield and Bank Loans. All of the International Bonds were negative due to currency issues. We are strategic and prepared for the environment of rising interest rates.
In the Alternative asset class, we liquidated two funds this quarter. One Global Macro fund was producing sub-par returns without enough downside protection. Another was a Long/Short Equity fund with a great investment process and investment team but the fund has too much exposure to value factor. The current market environment was not suited for picking stocks based on value, and as a result, the fund experienced large volatility that was not appropriate for Alternative asset class where we are seeking low and non-correlated returns from equity and fixed income with the downside protection. We have replaced these two funds. In our models, certain strategies including Vida Longevity Fund and a hedge fund will have increased exposure due to steady return stream and being most negatively correlated to the market.
Our concern list grows. High equity valuations and rising interest rates stress our markets on a fundamental basis that high consumer confidence and low unemployment in the U.S. ultimately cannot outrun. While our U.S. stock market rallies on greater company spending for stock buybacks than capex even after tax law changes are supposed to promote capex, high debt levels and increasing debt coverage expense will bleed into that. Globally, our strong Dollar may be its own worst enemy particularly in the midst of trade wars and politics. We continue to be vigilant and feel we have the best investments to participate in long-term economic growth and any potential interruptions to this rally in the near-term.
We are here to humbly serve you and encourage you to contact us with any questions you might have.
All the Best,
Mark, Bart, Leslie & Stella