We held our quarterly Asset Allocation Investment committee in March. As part of the committee process we assess the macro economic environment, the strength of the business cycle, asset valuations and sentiment.
- We believe that the US economy and Global economy is firing on all cylinders and expect it to accelerate through 2018.
- The broadening of the US recovery to middle class households, in our view, can lead to several more years of growth in the United States, independent of policy change.
- We believe tax cuts in the US will lift corporate earnings substantially and add to momentum in markets and the economy this year.
- We now believe the FOMC may implement as many as four additional 25 bp rate hikes into 2019, taking the Fed Funds target rate to a range of 2.25%–2.50% within 12 months.
- The Australian economy is continuing to grow steadily, but below trend. Non-mining business investment remains solid and employment is steady, although we remain concerned about the lack of wage growth, and high private debt levels which make Australia vulnerable to a global rising cost of capital if it eventuates.
- We continue to watch the US 10-year treasury yield which has spiked from 2.0% in September, to 2.9% today. President Trump’s policy of increasing the deficit risks this risk-free rate blowing out further over the next 12 months.
- Our medium-term view on interest rates is there is now a rising risk of inflation accelerating to a point where Central Banks will need to tighten more aggressively than anticipated by markets. This could put pressure on asset valuations which have been priced assuming a low inflation, low interest rate regime is likely to prevail indefinitely.
- Our overall view on valuations has not changed materially. Asset prices continue to trade at fair to expensive ranges with the US market being one of the more expensive markets and Australia, only slightly above fair value. If the discount rate moves materially higher in quick time due to rising interest rates valuations face the risk of further corrections as experienced in February.
While in previous updates we have devoted much time to presenting an update on the status of the global economy, our intention in this update is to spend less time on the current state of the economy and devote more time to the outlook. This is because we truly believe that we have arrived at a crossroads for Financial Markets and Asset prices.
The Global Economy
This is probably the easiest Economic update we have written in a decade, because the good news is the global economy is now firing on all cylinders.
The US, eurozone and China are all likely to grow well above trend in 2018 and global economic growth is set to remain above 3% for three consecutive years until 2019, a performance not achieved since the mid-2000s. We expect global growth to accelerate in 2018, led by the US.
The acceleration in private investment, pro-cyclical US fiscal easing and global monetary policies that are still very loose are all boosting growth in the advanced economies, while higher commodity prices and the weakening of the US dollar have underpinned an emerging market recovery. China is gently touching the brakes but is still prioritising high growth in the near term.
Growth in advanced economies is benefitting from a strengthening investment cycle as business sentiment improves, external demand picks up and labour resources become increasingly scarce. Tax reforms in the US could also boost investment. The pick-up in bank lending in the eurozone is particularly helping small and medium-sized firms, which account for half of capex, but reduced economic and policy uncertainty and rising capacity utilisation rates are also supporting the investment outlook.
Consumer spending in advanced economies is benefitting from the ongoing tightening in labour markets. Global monetary policy settings remain highly accommodative and credit conditions very easy despite the recent increases in bond yields. US fiscal policy is being eased aggressively, with the federal deficit likely to rise to over 5% of GDP by 2019 from around 3.5% in 2017.
Strong growth and declining unemployment have increased inflation risks in the advanced economies but a sharp surge in inflation still seems unlikely. Nevertheless, diminishing spare capacity is cementing the move towards monetary policy normalisation.
Central banks are becoming less cautious about normalising monetary policy in the face of strong growth and diminishing spare capacity. Fitch ratings expect the Fed to raise rates no less than seven times before the end of next year. And while still sounding tentative, the ECB is clearly laying firm groundwork for phasing out QE completely later this year. Fitch also expect the BoE to raise rates by 25bp this year.
We expect China’s economy to slow in 2018 as credit growth decelerates, housing sales flatten off and investment growth eases. Macro-prudential tightening has been a bit more concerted than expected but the authorities have recently reaffirmed their commitment to maintaining high growth rates in the short term. The wider emerging-market recovery has been helped by a weaker dollar and rising commodity prices, but these benefits are likely to fade as the US dollar should be supported by faster Fed rate rises and improving US growth prospects.
The IMF has upgraded growth forecasts as the eurozone recovery powers ahead, US fiscal policy easing by more than anticipated and investment prospects improve. US growth has been revised up to 2.7% in 2018 and 2.5% in 2019 from 2.5% and 2.2%, respectively. As we explain in our outlook, we believe this may well prove to be understated. Eurozone growth has been revised up to 2.5% in 2018 and 1.8% in 2019 from 2.2% and 1.7%, respectively. China’s 2018 forecast has also been revised up slightly (by 0.1pp) but growth is still expected to slow to 6.5% from 6.9% in 2017. Growth forecasts for Japan and the UK are unchanged for 2018 at 1.3% and 1.4%, respectively. We again see upside risk to Japan’s forecast.
As we stand today, things are looking good, and likely to get stronger. But what does that strength mean for investors who have become addicted to ultra-low interest rates? The key risk we see moving forward is a sharp pick-up in US core inflation – which would necessitate more abrupt, growth-negative adjustments in interest rates – and a major escalation in global trade protectionism. US-China trade tensions seem highly likely to increase in coming months, but the situation would have to deteriorate quite dramatically to adversely affect the near-term global growth outlook.
I haven’t mentioned Australia, much as there is not much new to say. Its steady as she goes down under. Housing is slowing, and consumer spending is constrained due to high debt and low wages growth. A lessening drag from mining investment and stronger non-mining investment (both public and private) along with solid export growth are likely to keep the economy growing and see a pick-up in growth to between 2.5% and 3%. However, growth is likely to remain below Reserve Bank of Australia expectations for a pick up to 3.25% this year and next. As a result, and with wages growth and inflation likely to remain low for a while yet, we have pushed out the expected timing for the first RBA rate hike from late this year into next year. We don’t believe the RBA will be the biggest influence on the cost of capital moving forward. That is likely to come from offshore.
The outlook…Trump Likely to be the Root Cause of the next US recession. But not for the reason you think…
For the last 9 years US, European and Japanese Central bankers kept the cash rate at zero and purchased treasury securities to lower interest rates out to 30 years. The mantra has been growth, growth, growth. And they have been pushing hard to achieve it. It finally looks like they have been succeeded.
The Fed has had the motor running at full steam for the first 7 years, and ¾ throttle for the last 2 years and the economy has responded. Not at a blistering pace, but a solid pace, averaging about 2% growth.
With monetary policy being a slow-moving beast, the Fed must adjust speed and direction early as there is a limit to how far they can push the economy. That limit is inflation. Inflation risk has not been forefront in the Fed’s mind convinced they have plenty of time to change direction before it becomes an issue.
So when will they brake? Many prominent Economists are will tell you it is certainly not yet, due to the modest growth experienced post the financial crisis. Rogoff and Reinhart’s brilliant book “This Time is Different” had a simple message. On average it takes an economy 7 years to return to normal after a balance sheet recession. Seven years was 2015.
Nonetheless, during this time the Fed has been persistently optimistic about the growth recovery. So, when they say they expect 3% growth, the collective response from the market was “we aren’t going to see it.”
But the world has returned to normal. Around the middle of 2016. Pretty much right on schedule for Rogoff and Reinhart.
It is time for the Fed to start easing back on the throttle. And so, they delivered 3 rate hikes in 2017. Indeed, the market never believed the Fed would deliver 3 rate hikes last year. After all, they promised the same in 2015 and 16. The chart below shows what the Fed projected for each year, and what the market was expecting, in the December FOMC meeting prior to year (with exception of 2019, which is forecast from Dec 2017 Fed projection).
Strangely, after the Fed finally delivered on their forecast in 2017, the market was still well under-pricing the Fed projection in 2018 and 2019. So what changed in 2017 for the Fed? The NAIRU2 gap. The unemployment rate moved decisively through their estimate of NAIRU in 2017.
Historically the Fed would have had cash rates about 1% above their estimate of neutral (which would be around 4% today) by the time the labour market was this strong. But given the scarring experience of the financial crisis, the Fed has decided to keep pumping the gas. So how much far have they been pumping? Well, try 3 years! They don’t forecast reaching a restrictive policy stance on interest rates until 3 years after breaching NAIRU…
So the Fed had planned to leave the tightening late, with the view that a steady pace of rate hikes now would slow the economy enough to limit further significant declines in the unemployment rate, and limit wage and inflation pressures.
This seemed to be working in 2017.
Enter President Trump
But then along came Donald Trump. During 2017, the market gradually gave up on the expectation that the Republicans would be able to deliver tax cuts. Indeed, in November the probability assigned by the market for tax cuts to be delivered by the end of the year was just 20%. The Tax cuts were delivered December 22nd and US GDP forecasts for 2018 jumped by 0.4% to 2.7%.
This is very solid growth for a period when the Fed is trying to brake.
The Republicans entered 2018 again grappling with debt ceiling limits and threats of government shutdowns. And while no one is paying much attention, they reached an agreement to pass a Continuing Resolution on February 4th that allows for a $390 billion increase in spending over the next year ($330 billion on defence). We believe this additional spending could have the ability to add another 0.4% to GDP in 2018. The US may well grow above 3% this year!
What we have is the Fed trying to cool the US economy and the President trying to stimulate it. This size Fiscal stimulus from the government, with the economy fully employed, has simply never happened in peace time.
What happens next?
The modestly good news is the new Federal Reserve Chair Jerome Powell knows he now must fight the White house.
“I think our view — my personal view — would be that there will be a meaningful increment to demand, at least for the next couple of years, from the combination of those two things” [tax cuts and continuing resolution], he said last month in front of Congress.
We believe we are going to see a Fed that is resolutely determined to get back to neutral as quickly and calmly as possible. So, we expect a Fed Funds rate hike every single quarter for the next 2 years. Isn’t that aggressive? No! The last hiking cycle in 2004-2006 was 8 hikes a year. And the Fed thought in hindsight that was too slow.
Will the Fed panic, and slam the breaks harder? It’s not impossible. What could that look like? In 1994 there were 300 points of rate hikes in 12 months. (See graph below)
Is that a reasonable comparison? In this cycle the Fed has left the braking late, much later than 1994, and there was no fiscal stimulus in 1994. The one comparison to 1994 was that growth sharply accelerated. Greenspan responded ferociously, and legendarily managed a slowdown rather than a recession. Equities finished the year flat.
This is the first time since the Great Depression that the Fed has been actively trying to lift inflation. So, it is the first time they have had monetary policy this loose when the economy is fully employed. Now many find it hard to imagine inflation ever developing. After all, we have cheap goods from Asia, and the internet ensuring people always find the cheapest price. There is simple no pricing power. Except input price measures globally are rising. And rising input prices in China leads to rising import prices in America.
And would you believe prices are rising on the internet in the US.
So, we have increasing input costs for goods. We have evidence of pricing power on the internet and we have the tightest labour market we have seen in 30 years, with a big acceleration in growth to come. We are now at the point when wages historically surge.
So, will wages growth breakout? Small business is telling us they plan to pay more….
While I have focussed much of this piece on the US, Europe and Japan are also experiencing a transition to faster growth and capacity constraints. See the chart below for labour shortages in Germany.
The evidence is also mounting in Japan……
You may think we are spending too much time worrying about something that may or may not happen and we should be more bullish in the current wonderful growth numbers and live for the day. The reason we worry is because if wages do break higher, the risk of the Fed over tightening and delivering a recession sky rocket.
- What would happen to bonds in this scenario? We will see serious capital losses.
- Interest rate sensitive assets such as real estate and infrastructure will be crushed.
- What will equity indices do in the next US recession? Historically, peak to trough, anywhere from down 20% to down 50%.
- Is that going to happen? Well, we think this all comes down to how high and how fast rates rise.
Assuming the current US growth continues, by the end of 2019, a “good” result would be a Fed cash rate of 3.5%, and a 10-year treasury bond of 3.75%. With that good result, equities should cope, with indices eking out 5-10% returns each year, and hopefully good active management can add some alpha above that, but with a lot more volatility than everyone is used to.
If equities are grinding higher and It is hard to envisage bond portfolio’s providing a positive return in a period interest rates are rising, a traditionally allocated balanced fund should generate a positive return, but only just.
Remember that is based on the “good” outcome of an orderly rise in rates.
If wages accelerate quickly to 4%, the Fed and asset markets have an almighty problem. Historically, the Fed would move aggressively to slow the economy and anchor inflation expectations. Historically, this typically resulted in a recession (the exception being 1994). It is very hard to slow an economy “just enough” hence the risk of overtightening.
We are not predicting inflation is returning to anything like the 1970’s, the point is only a slight pick-up in inflation could cause quite a lot of problems because, we have never seen asset markets more leveraged and invested in low inflation forever. Risk parity strategies so popular with the advent of algorithm trading will be toast in this environment. The combination of having to deleverage due to high volatility, and redemptions, could require as much as 1.5 trillion in bond sales from this group. Into a falling bond market.
So, should we worry?
We don’t think there will be problems in 2018, corporate earnings are very strong, defaults are low and there is fiscal stimulus on the horizon, so we wouldn’t be surprised if markets move to new highs above their February peaks in 2018. It is more likely markets will eventually be worn down by the cumulative tightening sometime in 2019 or 2020. But it is time to start preparing for a new environment, as we won’t pick the top of markets.
Consequences for Asset Allocation and Portfolio Construction
While we think there is still a little left in the cycle, particularly for more conservative investors, it is a time to be prudent in bonds, equities, credit, REITs and infrastructure. Anything that has benefitted from low interest rates in the world. We could be seeing a structural, once-in-a-generation shift to inflation. This will require radically different thinking for most investors. Treasury bonds will no longer be good portfolio diversifiers.
We need to be aggressive on any investment that can benefit from rising interest rates. Commodities, Gold, Global Macro Strategies come to mind as diversifiers and getting your stocks and sectors right is going to be critical in equities. A Fed that has been well and truly testing the limit, now has a massive fiscal stimulus at exactly the wrong time. We expect them to hit the brakes hard and hope for the best.
It is likely the easy money has been made from this cycle and things are going to get a whole lot more volatile and difficult from here. Just don’t be fooled if growth picks up and the short-term market response is positive. This growth is what will cause the tightening.
- Fitch ratings, Global Economic Outlook (March 2018)
- Ellerston Capital, Breaking the Limit (Brett Gillespie March 2018)
- The Pain Report, Brace yourself for a global inflation shock (Jonathan Pain, February 2018)
- Gavcal, SIC Conference presentation (Louis Gave, March 2018)
- Growth in 2015/16 was hurt by the 20%+ appreciation in the USD in H2 14. And compounded by 60% fall in the oil price in H2 14 as well, which led to a capex collapse in shale in 2015. Without these two exogenous events, the US recovery would have begun in earnest in 2015 right on Rogoff cue
- NAIRU is an acronym for non-accelerating inflation rate of unemployment and refers to a level of unemployment below which inflation rises.