China In The Crosshairs
economic growth remains fine for the time being (it actually picked up somewhat in recent quarters from its multi-year 2% average, but some of that increase may be transitory). Inflation has also increased, as it tends to at this point in the cycle when unemployment drops substantially.
The administration and Congress also recently passed two tax-cut and higher-spending packages, which will inject stimulus while adding an estimated $1.6 trillion to our government debt. This comes at an unorthodox point in the cycle, and has increased the risk of feeding inflation and higher interest rates rather than growth. It’s also contributing to the Fed’s tightening stance.
Meanwhile, we now see widespread heightened focus on trade – one of our top-five post-election factors – and the associated risk of reduced flows of goods, services, capital and labor. Trade deficits are viewed by many as bad, but it isn’t that simple. For instance, improving trade balances typically occur during recessions. President Trump’s words and deeds increasingly point to a “plugging” of our economic borders. It’s premature to say how significant this will be in the end, but the direction of travel is of concern and may lead to talk of stagflation.
So it’s hurry up and wait. We all want to read The Wall Street Journal from April of 2020 and see how the story ends. But if there’s one trademark of this cycle it’s its gradualism.
Please update us on the most recent growth and inflation data.
Starting with growth, things have remained fine in recent quarters, both in the U.S. and abroad. At home we’ve seen growth average close to 2% for some time. Recent quarters have actually been better than that. This could partially be “make-up” for some previously weak¬er periods. And we think that we’re still seeing lingering replacement demand after the August and September hurricanes that particularly hit the Gulf Coast states.
On most foreign shores growth is also moderate, be it in developed or emerging nations.
On the inflation front, we’re also seeing a step up, and here that’s not as positive. After years when markets worried about possible deflation – i.e., falling prices – we’re now at a point in the cycle when infla¬tion normally emerges. And so it is, in both general prices and wages. Ultimately, this could sow the seeds of a slowdown in growth.
Why does inflation accelerate at this point in the cycle?
Typically it’s because we use up capacity – which includes things and people – and then business needs to “bid-up” to attract and acquire new resources to meet ongoing robust demand. In the current environment, we still have unused manufacturing capacity. But manufacturing is a fairly moderate component of our economic activity, representing close to 10% of our total employment. On the much larger services side of the economy, it appears we do not have a lot of extra capacity (largely people). And with unemployment near a very low 4%, businesses increasingly are paying higher wages to fill even a portion of the near-record number of job openings.
This follows a well-worn path, and though the current cycle has moved more gradually than in the past, the flight track looks similar.
How worrisome are shifts in inflation?
The level of inflation that we’re seeing today and anticipate in the near future is far from crisis levels, and nothing like the 1970s for instance. The key risk from inflation arises because it could be underestimated in the financial markets.
The other likely spanner-in-the-works of inflation arises from fiscal stimulus. As you know, our Congress and administration have just passed two packages of tax cuts and higher spending. We estimate that together they will generate about $1.6 trillion of new debt.
Now, this is a very curious time for fiscal stimulus. Typically we see government largesse occur when the economy is weak and elected officials feel compelled to offset poor growth. However, these packages (which are front-loaded, too) have passed at a time of robust, steady growth. The worry is that, given the economy’s inability to find people to fill the jobs that are open as it is, this new stimulus may lead to higher prices rather than higher growth. And that would inevitably lead to higher interest rates, which could harm both GDP and financial markets.
And is the Fed doing anything in response?
The Fed has been on a path of gradual tightening for some time, and this context only supports further steps in that direction. If this continues we may see the return of a dreaded word from some previous cycles, stagflation, when inflation and interest rates rise at the same time as growth wanes. Eventually these policy actions could certainly trigger a slowdown, even a recession.
We are not yelling “fire” quite yet, but the probability is rising. Such a scenario would not be a great combination for owners of stocks and bonds, but it’s just fine if you own short-term instruments like money market obligations and short-term bonds, which are often described as “cash.”
Let’s shift to the talk of the town – trade. What’s your take on the message from Washington?
Soon after the election late in 2016 we developed a framework of five key factors by which we would measure the new administration’s and Congress’ impact on financial markets. This framework remains valid to this day and trade was our first issue – one that has now taken center stage.
President Trump’s words (his rhetoric is increasingly ferocious, possibly part-and-parcel of his negotiating style) and deeds (various announced tariffs, duties and other actions) around trade increasingly reveal that our borders are not as open to various flows as they were for many decades.
It is still too early to know how extensive this tightening will turn out to be. But markets are clearly unsettled about trends, as most observers see a fairly open architecture as beneficial to growth overall. If this were to worsen meaningfully, the long-term outlook for global growth could weaken.
If we had to bet now and go fishing for the next 20 years, we would likely conclude that the bark is intended to scare and some negotiated solution is more likely than not. Clearly though, the risk has risen substantially, and the outcome of the recent revised trade agreement with South Korea suggests that we could be declaring victory on trade but effectively delivering very little change.
In your mind, what’s the real issue with trade?
The current administration – and many voters – view trade deficits as eviscerating, and this is both driving emotions and guiding policy. We would argue that this notion is far from clear. We typically see improvements in our trade balance during recessions and larger trade deficits in periods of strong growth. We’d argue that growth is better. But actions to reduce trade imbalances could, if poorly designed, actually cause harm. And, even as trade is now getting the attention, what ultimately will drive things is interest rates, fiscal policy, employment, wages/inflation, etc.
By the way, remember that large tax/ spending stimulus we talked about earlier? That will only make the trade deficit worse (all else being equal) since it represents re¬duced national savings – the key driver of trade deficits. It’s never simple, is it?Download PDF
The Beginning Of the End For “Tina”?
After a stellar start to the year, things changed suddenly. In an often-forecast correction, U.S. markets caught the flu late in January and were laid up through the quarter.
The key catalyst was higher readings for inflation, and wage growth in particular. More recently, the heightened risk of global trade conflicts and the market’s large exposure to a small number of beloved companies aggravated concerns.
Suddenly, investors shifted from a TINA mode – i.e., There Is No Alternative to stocks, so forget about fundamentals and just buy – to recognizing that the vaccine against bad news did not provide full immunity.
Equities fell from their late-January peak by around 10%, which typically defines a correction. But, given the strong early-year start from the gates, U.S. returns for the quarter were a more modest absolute loss. More recently, however, investors seem most focused on price weakness, and risk/volatility has clearly increased, as many had worried would happen for some time.
Valuations remain stretched, whether one looks at Price/Earnings, Price/Sales or myriad other metrics. As a result, this market remains dependent on earnings growth, which may be flattening.
The year started so well…then it all came tumbling down.
Indeed. For the first four weeks, it appeared that the two new tax stimulus packages, total¬ing about $1.6 trillion of new deficit spending, were going to grease the economy’s and finan¬cial markets’ wheels. And then they didn’t.
U.S. stocks, which had risen about 7% from the beginning of the year, fell nearly 10% in short order. As you know, that’s the broad definition of a correction. There is no magic to that number, but media headlines and many investors fixate on it, so it’s a refer¬ence point that many recognize.
What happened to ruin the party?
The short answer is faster inflation. Late in January, new releases of consumer prices and wage growth revealed that inflation was accelerating above market expectations. Long lulled into thinking that inflation was never going to rise, this was a cold shower. And even though those numbers were somewhat softened with subsequent releases, they still paint a picture of gradual acceleration in infla¬tion that now exceeds the Fed’s long-term tar¬get of 2% and may well be inconsistent with the current price level for financial markets – including stocks and bonds, incidentally.
But it seems hard to believe that a gradual price acceleration would do this, isn’t it?
It’s all about expectations. If investors become convinced of a favorable future out¬come, and then reality turns out to be quite a bit different, hopes can be dashed and market reactions severe.
And even though inflation can be blamed as the primary initial trigger late in January, it wasn’t the only one. The now-sobered market has found other factors to see with a newly jaundiced eye.
The administration’s strong rhetoric and cumulative actions on trade, for instance, increasingly suggest a risk of economic con-flict, which financial markets dislike. Further, many have observed for some time that cer¬tain technology and consumer discretionary stocks (often labeled as FAANGs or some such) now represent a meaningful component of the broad market that even global managers have piled into. Whereas in the past this was viewed enthusiastically, this concentration of stocks loved by many but priced with little room for disappointment quickly became an area of concern. Thus, volatility rose sharply. And volatility is one expression of risk.
And risk has been low for some time…
Very much so. Unusually and unhealthily low, in fact, suggesting investors may have previously let their guard down. They seemed to believe that we were inoculated against the “common price drop,” and grew resigned that, though stocks were expensive, so were other assets, and, since “There Is No Alternative” (TINA for short), they had to buy, as cash is a controversial and unpopular alternative.
But look, it’s not the end of the world. Not yet. Corrections are common, and, given the sharp rise at the beginning of the year, the quarter revealed a modest loss for stocks in the U.S. Foreign stocks broadly did similarly, with a better outcome for emerging markets and a somewhat weaker result for developed non U.S. markets (all measured in U.S. dollars).
So do you think this is just a correction?
“Just a correction” seems a little light-hearted to us.
We do observe that, so far, the damage isn’t particularly extraordinary, and we could easily see the market rebound to previous highs. But we remain of the view that there are many factors that we put into the “not great” bucket. As we survey the world, some equity markets do appear dearly priced. As a result, future stock performance is constrained and increasingly depends on earnings growth, as price/earnings multiples won’t likely help much and could actually hurt.
Finally, earnings growth, particularly pre-tax earnings, which we favor as a metric and causal factor for stock market performance, may be past its peak.Download PDF
Fixed Income Portfolios
The Wolves Approach
For quite some time we have expressed concern about the risk of rising inflation and higher interest rates. After a pause in mid-2017, U.S. inflation has been picking up steam. By March 2018, U.S. CPI climbed to 2.4% year over year. The U.S. Core PCE deflator, an inflation gauge closely watched by the Fed, also reached 1.6% year over year in February, and is now running well above the Fed’s 2% target. The threat of higher inflation, which has been underappreciated by financial markets, is finally back in the headlines.
What’s the prospect of inflation?
We’re expecting inflation to go higher from here, and the spark seems to be driven by cy¬clical factors. U.S. and global growth ticked up in 2017 and unemployment rates in major developed countries, such as the U.S. and UK, are reaching historical lows. More profound factors, namely increased government debt (e.g., $1.6 trillion from two new tax-cut pack¬ages), unfunded fiscal spending, and possible higher tariffs as a result of rising protectionist sentiment, could push inflation even higher.
Have you seen any new moves from the Powell Fed?
For now, the Fed¬eral Reserve under new chairman Jerome Powell is staying the course de¬signed by previous chair Janet Yellen. As expect¬ed, at the March FOMC meeting the Fed decided to raise rates by 25 basis points and signaled at least two more rate hikes for 2018, maybe three. In its released Summary of Economic Projections (SEP) for the next few years, the Fed suggested that it’s optimistic regarding the future performance of the U.S. economy.
We don’t expect the Fed to deviate much from its traditional role. Of course, some worry that Powell is more of a political figure than a “technocrat,” but he is surrounded by a strong, knowledgeable and experienced cast.
So, should we conclude that interest rates will continue to rise in the foreseeable future?
We certainly feel that risks point in that direction. For example, the 10-year U.S. government bond has risen from 2017’s low of 2.0% in September to 2018’s high of 2.95% in February and is hovering around 2.9% as of this writing. With rising inflation expectations and a continuation of the Fed “normalizing” monetary policy, inter¬est rates could head higher in the foreseeable future unless some unexpected events knock the U.S. economy back into recession.
How is HCM’s fixed-income portfolio positioned for this rising-rate environment?
One of the biggest risks for bonds in a rising interest rate environment is duration risk (i.e., the longer the maturity, the higher the price volatility). HCM’s fixed-income portfolio is well positioned to weather this risk. Our bond duration is, on average, only half of the benchmark’s. This will protect capital in the event rates rise.Download PDF