Government Stimulus Refreshes Growth
There are several counter-currents in our economic habitat.
The new prevailing force arises from the key legislative achievement of this administration and Congress – a big fiscal boost to demand from tax cuts and new government spending. It is elevating growth for the time being above the 2% to 2.5% trend of recent years, though it comes with a price.
In the other “corner of the ring” we observe a number of opposing forces, most of them smaller, but some bulking up for the struggle.
The “chronic” or persistent one remains monetary policy. The Fed continues to raise rates and has in recent months accelerated its removal of Quantitative Easing by shrinking its ownership of bonds, which represents tightening by a different name.
The “acute” or more recent events are numerous. They include higher oil prices; a somewhat stronger dollar; inflation, now above the Fed’s target; and China’s new focus on controlling excesses in debt and property speculation, which is slowing growth. Of possibly higher risk is the trade skirmish that’s stubbornly nearing the point of no return. If it remains on its recent glide path, it will inevitably lead to the question of who loses the least. For, surely, most will lose.
Have you seen any changes to growth from the “fine” label that you gave it last quarter?
Sure. It’s become somewhat finer.
Economic growth is doing well. Though the first quarter slowed back to the 2% trend pace of several years, we’re likely to see a bump up in the second quarter which, based on incomplete data, could easily fall between 4% and 5%.
We believe this is exaggerated by a temporary boost in activity to beat increases in tariffs implemented or threatened by the Trump administration. Thus the underlying, sustainable pace is below that, though nev¬ertheless robust as the estimated $1.6 trillion fiscal boost works its way through the economy, front-loaded in the early years.
Well, is it clear sailing then as we scrutinize the horizon?
The fiscal boost is the principal factor boosting growth, though healthy commodity markets (until very recently, that is) are also helping.
Of course, it would be myopic of us to just rejoice at the blue skies above and not look farther afield. We do see some clouds out in our field of vision, and the winds tell us that there may be more over the horizon.
Well, it’s best to know the possible weather before we venture too far from shore, so tell us about those “meteorological” risks.
Having just returned from Mount Wash¬ington in New Hampshire, where the second-highest wind speed on earth was recorded (231 mph) and the weather can change violently in the few hours it takes to make your way up from the base, we’re reminded of the value of being prepared.
We do see a number of factors that are tugging the other way from government tax cuts and spending generosity – none sufficient to change the current narrative, but more than enough to potentially change the future trajectory of growth and earnings.
And what’s the most important one?
We would place monetary policy at the front of the line. It’s long-standing and acts gradually, but over time it tends to have the strongest impact. The Fed has been on an in¬exorable path of higher rates, and the recent fiscal boost sustains it due to the market’s con¬cern with higher budget deficits.
And that’s not all. During the days of the Great Recession, the Fed implemented unorthodox Quantitative Easing, buying trillions of debt from the U.S. Treasury (and other obligations) to inject more liquidity into the real economy to prevent a depression. Well, we’re on the “lee” side of that, and along with higher rates, the Fed is now reducing the number of bonds it owns, which acts to reduce liquidity in the system. And, in a modern economy, liquidity or credit creation is the fuel upon which growth rises or falls.
You’ve been consistent in your focus on monetary policy, and we like that. So what other things are hiding under the bed?
There are several, some bigger than others. The more ephemeral ones include high-ish oil prices, which have been buttressed by col-lapsing production in Venezuela, among other factors. And a stronger U.S. dollar, though we would note that its 4.5% gain in recent months really isn’t extraordinary, particularly when viewed in the context of its previous 12% drop since early 2017.
Of higher import, inflation is now running over 2%, and that’s meaningful because that happens to be the Fed’s target. The Fed has prepared the market to expect inflation above 2% for a little while, and we happen to think this is reasonable policy. But the throttle or brake of monetary policy works with a time lag and, currently, interest rates are a bit low for the pace of inflation.
Finally come the potentially most consequent factors – China’s debt management and the growing global trade tensions. That’s a lot under one bed!
OK, we value drama and are suitably apprehensive. Tell us about those last two.
Though Chinese central government debt is quite low, the corporate sector has gone on a bender. Many heavy borrowers are govern-ment or quasi-government entities – national champions that can be merged out of exis¬tence but won’t be allowed to fail. In effect their debt is the government’s debt. Further, households have speculated in second homes, helping to drive property values to very high levels, which is worrisome even if buyers also invest large portions of equity.
China has decided to repair these excesses and also curb “shadow banking” as a way to de-risk its economy. If maintained (and they could soften it) this policy would likely damp¬en growth and increase the risk of a policy er¬ror. This is behind the drop in Chinese stocks, which exceeded -20% from their recent peak.
Then there’s the trade tension we’re all well aware of. Though we’ve leaned toward the view that we will eventually come to some compromise, and victory will be declared before the November election, we also note that the numbers are piling up. Tariffs have now been imposed on nearly $165 billion of total trade, and we’re approaching the point of no return, not without losing face. We’d stress that research convincingly argues that in a serious trade conflict, even if trade deficits are reduced, total trade will fall. There are only losers in these scenarios, and losing the least will not prevent higher prices, higher unemployment, reduced income and a lower standard of living for the vast majority. But, alas, emotions may come to rule.
One last thought that brings together these two factors. The aggressive Trump posture on trade may give Chinese leadership a politically safe fall guy for its efforts to curb debt and lending excesses as well as cut back on polluting heavy industry. These are necessary reforms in China, but the Communist party fears their inevitable job-reducing impact. How convenient if they can blame it on the U.S. administration! Unfortunately, it could also lead to intransigence – never a good thing for growth or markets.Download PDF
A Stage Of Ambivalence
This year has seen heightened uncertainty and global equity returns near zero. After a stellar 2017, investors are struggling to balance pressures to discover new springs of growth in a valuation setting that most acknowledge is more dear than cheap.
U.S. government tax cuts and spending increases are drawing out GDP and triggering 20+% growth in earnings per share. But fiscal policy has historically been a weaker force than the level of interest rates, which are being driven upwards by fears of rising deficits that inevitably arise from that same fiscal boost. Thus, in the U.S. we’re likely closer to late than early economic stages, and could even see an overheating economy already unable to fill record-level job openings. Late-stage economies merit close focus on valuations and earnings growth as price-multiple expansion is not a likely source of return. Thus, one has to decide how much risk to have in a portfolio which seeks to balance growth and capital preservation.
Through June, three stocks contributed 69% of the S&P return, and six stocks generated effectively all of the return*. These names are major positions in many U.S. as well as global mandates. We view this concentration as a source of risk. And, though we maintain plenty of equities in our portfolio, we continue to carefully aim our antennae at these developments.
We perceive more ups and downs this year. Is that fair?
That’s an accurate picture.
Last year was one of strong performance, though equity returns far exceeded gains in earnings, stretching valuations. This year started off well, but then nerves set in, volatility shot up and prices fell. The second quarter saw calmer waters, but we’re in a more subdued en-vironment than 2017 and investors are increas¬ingly being tugged in two directions.
Stock returns to date across the world are effectively zero overall, with the U.S. modestly higher. This is similar to returns in hedge funds and compares unfavorably with even return on “cash” and does not compensate in¬vestors for the much higher volatility of stocks.
On the one hand many feel pressure to buy something – anything. Cash positions aren’t always understood by clients, who continue to seek growth and still hear good economic numbers. On the other hand, most profes¬sional investors recognize that things aren’t cheap and haven’t been for a while, so one must be careful, as the growth of today could easily and quickly become the obvious risk of tomorrow. It was so with housing in the 2000s, with technology in the late 1990s, and just about every cycle before that.
See, you said it – good economic numbers. It’s exactly what we wondered. What’s the problem, then, if growth looks good?
Economic growth is indeed robust. We have a record level of job openings and can’t find people to fill them. We’ve just about drained the well of unemployed workers – particularly those with the skills required to fill the many well-paying job openings – as most tiers of unemployed are near record lows.
Several factors contributed to this, but ris¬ing commodity prices have helped the newly enlarged U.S. oil and materials sectors. And, in the last few months, the economy and earn¬ings have benefitted – and will likely continue to benefit – from fiscal stimulus. The signature economic policy of this administration and Congress is 2018’s large cut in taxes and si¬multaneous large increase in spending.
Right. So, again, what’s wrong with that?
Fiscal policy is one important part of the puzzle. But it must be weighted against other causal factors, and foremost among those is the level of interest rates, or monetary policy. And this is decidedly going the wrong way, firstly in the U.S. and following elsewhere, for two primary reasons.
The Fed and other central banks have de¬cided that economies no longer need the level of stimulus that they injected previously, and higher rates are meant to bring about a more neutral stance and eventually to apply the brakes in case of overheating. Secondly, espe¬cially in the U.S., markets are quite worried about the dark side of government generosity. Washington already has near-record levels of debt, and this year’s policies will surely drive deficits even higher, aggravating our debt bur¬den. That tends to be inflationary, especially if implemented when there is little slack, like in today’s job market. Which typically drives interest rates upwards. Which tends to slow or reverse earnings growth and price/earnings ratios. Maybe not immediately, but we must anticipate it.
Got it. Much easier to see now. And you’re painting a picture of higher risk?
Exactly. We do feel that the fiscal boost, taken in the context of higher interest rates, rising budget deficits, heavier government, corporate and household debt burdens, and other factors, does not alter the reality that we are closer to late-stage than early-stage, when it’s very important to monitor earnings growth and valuations, and emphasis on risk management is key.
Risk is an integral part of our process and has moved to the center of our radar scope in the current setting. For instance, a recent analysis* reveals, startlingly, that three stocks represented 69% of this year’s price gains in the S&P 500 through June; a mere six stocks were responsible for 99% of the return; and the top-10 contributors accounted for 122% of price gains. Further, a small number of stocks represent meaningful components of many portfolios – both those mandated to track U.S. indices, as well as some with global mandates, which pose fewer restrictions on managers, many of whom are buying and driving up prices of select stocks.
We think that’s risky.
Ugh. We see your point.
And just one more insight.
The fiscal boost is front-loaded, much of it occurring in the early years. The cut in corporate taxes is leading to gains in earn¬ings per share of over 20%. But we advise caution on how to interpret these numbers. The bump is one-time and it’s exaggerated by a reduced share count from higher buy¬backs, thus may not translate into higher multiples. Thus total, pre-tax economic earn¬ings are quite different from earnings-per-share, moving rather more sluggishly.
Please don’t misunderstand. We don’t think that the wheels are coming off. And we are maintaining a large position in equities in our portfolios. But we do choose to focus on risk, especially with the trade tussle underway.Download PDF
Fixed Income Portfolios
Inflation Measures Rise And The Yield Curve Flattens
Inflation continues to accelerate in an environment of gradual stimulus withdrawal, buoyed by climbing oil prices, tax cuts, fiscal spending, and economic expansion. The Fed continues to telegraph its intentions, reduce its balance sheet, and raise interest rates, with two rate increases so far this year. Treasury yields continue to experience upward pressure, but unevenly: the yield curve has flattened considerably over the course of 2018.
There are several references to rising inflation in this issue. Your thoughts?
Inflation is indeed on the rise. In June, core CPI printed a 2.3% rate year-on-year. This is the fourth month in a row where we’ve seen a figure north of the Fed target rate of 2%. Compare that with a weaker 1.7% year-on-year this time last year, at a time when the Fed Funds rate was lower than it is today. Similarly, the Fed’s favorite barometer of consumer inflation, the core PCE deflator, reported 1.96% year-on-year inflation in May, almost a half-percent higher than that reported in May 2017. For various reasons we’ve noted in our discussion here, including rising oil prices, tax cuts, and increased fiscal spending, it’s quite possible that inflation will continue to be robust.
Tell us about the fixed-income landscape in this rising-inflation environment.
It’s interesting to see how treasury yields have moved in 2018. At year-end 2017, the 2-year treasury yielded 1.88%. It now yields 2.60%, or 0.72% more. The 10-year treasury, which began the year yielding 2.40%, now yields 2.85%, up 0.45% this year. This means that the closely-watched 2-year/10-year yield differential stands at 0.25%, less than half the 0.52% at which it began 2018. Market pundits are concerned that this yield curve differential may continue to flatten and ultimately turn negative, which would ‘invert’ the yield curve (as the 2-year treasury would then yield more than the 10- year treasury). This inversion may suggest that the Fed is raising rates too quickly and could potentially hurt banks as they borrow short-dated yields and lend long-dated yields.
Doesn’t an inverted yield curve also foreshadow a recession?
It typically does. In fact, the inverted yield curve has anticipated all nine recessions in the U.S. since 1955. However, there are several factors that may cause this time to be different: the Fed is thoughtful and transparent, rates are low, and the U.S. expansion continues to be strong. Regardless, we pay close attention to the economy and markets, and our investment discipline prepares us for either outcome.
How is Hamilton Capital’s fixed-income portfolio structured to navigate this environment?
We are very conscious of duration risk – the risk that, when interest rates rise, longer bond portfolios suffer greater price declines than shorter bond portfolios – and have structured the portfolio consistently with this rising-rate environment. With our bond duration at one-half of the benchmark duration, the fixed-income portfolios will continue to preserve capital should rates rise. Additionally, our corporate bond portfolio is very highly rated, and this portfolio decision will provide additional insurance against credit events.Download PDF