Economic Outlook

Structurally Speaking

Executive Summary

Our time frame for portfolio allocations of “the next 18-24 months” exists in the context of an analytical framework that is rather longer.

So far in the 21st century, the world has seen three major and connected macro events that defined much of the economic backdrop for both financial markets and Main Street: the emergence of China; a commodity super cycle; and a credit boom-and-bust, most often associated with U.S. housing and banking, but much broader in scope. The bust, in turn, triggered a global wave of central bank stimulus that we may never see again in our lifetimes.

China’s integration into the global trade framework unleashed the equivalent of an accelerated baby boom, suddenly drawing hundreds of millions of “new” workers into the world’s modern manufacturing labor force. This, along with excess global liquidity, triggered a sharp rise in commodity prices. Until starting to reverse in 2014-15, these structural events created massive new wealth in Asia and commodity-producing emerging and frontier economies while simultaneously also raising the standard of living of the vast majority of us in the developed world.

Economies are, ultimately, driven by labor-force and productivity growth. The Chinese “baby boom” is now largely behind us. As we look at the next decade or two, we find it difficult to identify probable new demographic sources for a comparable, quantum boost to global growth.

Further, the unprecedented monetary stimulus that emerged in the hangover of the Great Recession prevented a depression but also caused an expansion of debt in many pockets that is still contributing to booming stocks. We are far more likely to see monetary snugging than anything resembling the post-crisis priming. Given the weight of debt, this doesn’t spell acceleration either.

We hear that growth remains just fine, and in last quarter’s CMR you argued that you don’t expect an end to Shangri-La imminently. Is that still right?

Correct. Economic growth remains robust, boosted by the rebuilding after August and September’s hurricanes and other factors. Meanwhile, inflation is still under control, though it has perked up. And, finally, the U.S. has a near-record number of job openings, and new positions are still being added, though at a gradually slowing pace. We would not be surprised by GDP growth approaching the 4% range, temporarily. This setting is keeping the Fed on its glide path of further increases in interest rates until it eliminates the current stimulus posture and eventually becomes restrictive.

Got it. That being so, let’s take a moment and think longer term. You do that, don’t you?

And how.

We’ve previously described our 18-24-month time frame when we design portfolios. That means each morning starts a new time horizon for us.

That said, this investment strategy time frame exists in the context of an analytical assessment that is quite a bit longer, and we spend a good portion of our time developing, challenging and updating this multiyear

Well, let’s then reflect on things past, and any implications thereof for things future. For growth, for instance.

Terrific. But be careful what you wish for. We love talking about this stuff. And we think growth is a very good place to start. In fact, it’s one of our favorite things!

If we head back in time to the turn of the century, we saw a few events that we feel are the key triggers for our experiences since.

First, China joined the WTO (World Trade Organization), a set of trade rules that many countries have agreed to abide by, in December 2001. Though this forced a significant opening of its economy, it also granted it access to a previously restricted and very large new set of clients: U.S., UK, European and Japanese consumers.

Why did China do that?

Well, in our view, the Chinese communist leadership exists in constant fear of popular revolt against its singular authority and it has fundamentally struck a bargain – the Party creates jobs and the population does not challenge it, politically.

The Chinese watched the mess that the free-for-all collapse of the Communist Party in Russia produced after glasnost. They long decided that they needed to follow a different path to protect their Party’s power and prevent the massive, and corrupt, transfer of wealth from the Party to the private sector that Russia suffered through. So Beijing started a process in the 1980s of cozying up to the world economy, culminating in deeper integration via WTO membership.

And what impact did this have, in China and elsewhere?

Access to the world’s consumers unleashed a powerful new catalyst for growth. Over a short period of a decade or two, China shifted hundreds of millions of laborers previously struggling in the highly fragmented and inefficient farming sector and offered them up as a new source of cheap labor to the world’s manufacturers. They, in turn, could meet the needs of the world’s consumers – for clothing, shoes, cell phones and flat-panel TVs, for example – at a much lower cost of production.

This triggered a meaningful increase in associated jobs in developed nations like the U.S., which far exceeded those (though there were many) that were displaced by the new, large, and low-cost Chinese competitors.

This large increase in the world’s labor force was akin to a sharp increase in the world’s growth potential – a “baby-boom” of sorts, without the toddler and adolescent stages, which accelerated its effect. Lenders gleefully provided extensive debt – too much, as it turns out. Until it all went south, wealth and standards of living increased sharply nearly everywhere, including in developed countries. Commodity prices boomed in the mid-2000s, visibly boosting well-being in commodity-producing nations like Brazil, Angola, the Middle East and Russia, which had been previously left out.

So what does that “lesson learned” tell us about the next decade or two?

Fundamentally, economic growth is the result of two things – productivity growth, which shifts slowly, and labor-force growth, which is predominantly a demographic factor that normally changes slower still.

Looking ahead, we are having some difficulty identifying an event(s) that comes close to the sudden and large increase in the world’s labor force that we just lived through in China. In fact, a careful survey of the world finds the opposite – aging populations and low birth rates nearly everywhere, certainly in Japan and Europe/UK, only moderately better in the U.S. and even in China, which covers much of the world’s GDP pie.

Just about the only places with the demographic wherewithal to generate anything remotely similar to what China triggered are India and Africa. However, at this point it does not appear that either region is quite ready to implement “in size” the kind of creative policies that are needed to translate that potential into reality, be it reasonable government budgets and central bank interest-rate policies, ease of forming and doing business, reliable legal and regulatory environments and absence of corruption, strong education/training mechanisms, and/or a setting for robust political dialogue. Not quite yet.

The only other possibility seems to be a step-up (or re-entering, as in the U.S.) in women’s and millennials’ participation in the labor force. But these are likely to be gradual forces.

All these factors point to moderate average growth rates for a decade or two.

And lastly, this underlying, secular environment is merging with another, shorter-term, cyclical setting – the fact that some economies are already running near full capacity, and others are well on their way. This suggests that global growth is unlikely to experience a push which might have otherwise occurred if we were starting from a position of very high unemployment and under-used capacity.

So, overall, it looks like a backdrop where both the long-term and medium-term point to moderation. But we’ll keep looking under rocks yet unturned to see if we missed anything.

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Equity Portfolios

More Strong Gains

Executive Summary

Our equity-focused portfolios have, once again, generated considerable gains for our clients, with percent returns in the mid-to-high teens last year.

What now? We sense an asymmetrical opportunity ahead, where the pleasure from possible gains feels outweighed by the risk of loss of wealth already earned and built into our clients’ dreams.

Our strict discipline, emphasis on an ounce of prevention, and full valuations are guiding us to “participate but moderate.” We aim to benefit from robust markets so long as earnings gains warrant it, while carefully scrutinizing those markets we view as particularly expensive. After all, we aren’t market timers, and the risk-management DNA in our veins often leads us to early caution.

Today’s world in many ways is similar to past market booms, but with new terminology. These days some investors exhibit FOMO – the fear of missing out. But we feel that our clients particularly value gains already achieved that now support what were before mere castles in the air. We are endeavoring to avoid erosion in those foundations.

Our peripheral view of headlines during the quarter suggests enthusiasm, maybe even euphoria. Things are still good, we gather?

Equity markets had another strong quarter to close the year. Post-hurricane rebuilding and repair, rising commodity prices, and the promise of stimulus and incentives from the new tax plan held the lure of continued economic growth and possible higher investment and return of capital to shareholders, propelling stocks to more gains.

Our equity-focused portfolios returned in the mid-to-high teens for our clients. Not bad for a late-stage year. You’ve heard us argue that one-year results are not very meaningful. But even over the last, say, five years, our clients have seen their managed investments increase by double digits. Annually!

Without going into infinite, confusing detail, can you give us the skinny on the tax package?

The tax cuts were substantially (around two-thirds) aimed at corporations, with just enough sweetener added for individuals to create broad support. Further, it’s a net stimulus in that it’s not offset by increased tax revenues elsewhere. That’s the good news. But that also means that the budget deficit will be increased by, we estimate, around $1.3 trillion. That’s more than the government spent in the post-Great Recession period 10 years back.

Though many are hoping for a sharp increase in capital investment, we suspect that the greater benefit will come in the form of higher dividends or buybacks. And how much of that is already built into stock prices is up
for debate.

So this market has continued to deliver. But what now?

What now, indeed. The S&P 500, a popular and just-about-best-performing benchmark anywhere, has gained nearly 300% since the bottom in early 2009.

The environment then was one of despair, with many convinced that our problems were irreparable. But policymakers, monetary and fiscal, took a firm stance of support at the right time in the cycle – when Main Street needed stimulus to put all the unemployed back to work – and the rest is history. Fast forward to today and sentiment is clearly positive. Fiscal stimulus will likely again be injected even though the economy is already stretched. These “meds” may not be needed and could risk triggering inflation as much as new growth. As a result, the monetary doctors are on their back foot, fearing overindulgence that could lead to the economic heartburn we know as inflation.

Bottom line, we see an asymmetrical set of options.

But if the markets are strong, and the music is still playing, don’t you need to keep dancing?

You know, we’ve seen this movie before. Initially investors are skeptical, even though the causal or root forces for stock prices (earnings growth, low interest rates, possible stimulus from currency shifts or government budget stimulus) are benign.

Then, as markets continue to do well, fears abate and folks begin to pile in as confidence grows. The problem is that confidence is a very fickle friend – always providing the exact wrong advice. It’s always highest when markets are about to drop and it’s lowest when markets are about to rise. Every time. Some friend…

We ignore confidence because it’s not predictive – what “high” and “low” mean change from cycle to cycle. Rather, we stick to our discipline, which emphasizes valuation and other causal factors. We want to see gains in earnings to come through and other supportive policy to be all-in.

Boy, but what if markets keep rising?

Yes, we’ve been there before, too. Several times. And today they call it FOMO – fear of missing out. We feel that investors tend to see gains in their portfolios and quickly build dreams on them. Thus, we feel that a dollar already gained and mentally counted on can be worth rather more than a dollar that may or may never arrive – particularly at times when risks are rising and dreams can evaporate with a meaningful pull-back.

Our risk-management emphasis also lends weight to an ounce of prevention, and can lead us to be early. Full valuations are holding us back. But we’re also looking for markets, which can be abroad, that offer us robust earnings growth and the most supportive interest-rate environment possible.

So the phrase for us is “participate but moderate” – balance our yearning for growth with the desire to protect gains already achieved, looking askance at exposing gains to disproportionate risk.

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Fixed Income Portfolios

Inflation Pressures and the Prospect of Higher Rates

Executive Summary

As the mantle of Fed Chair passes from Janet Yellen to Jerome Powell, the Fed continues to withdraw stimulus from the economy, with three rate hikes in 2017 and more planned for 2018. As headline and core inflation gradually rise, bond yields have experienced upward pressure from both Fed action and inflation pressures. Our thesis that inflation is underpriced in the fixed-income markets has led to our bond portfolios maintaining shorter durations than those of our benchmarks as a means to preserve capital in this environment.

How did bond markets fare in 2017?

2017 was a most interesting year for U.S. treasury markets. Consistent with the three rate hikes by the Fed for a total increase of 0.75%, the 2-year treasury, which began 2017 yielding 1.19%, ended the year at 1.88%. What’s noteworthy is that the 10-year treasury, which started the year yielding 2.44%, ended the year almost unchanged at 2.41%!

What transpired was that the treasury yield curve ‘flattened’ over the course of 2017, as short-dated interest rates rose in lockstep with Fed action, while long-dated interest rates remained unchanged or even declined. For various reasons, including the continuing demand for long assets by pensions and foundations, longer-duration treasuries continued to be well-bid in 2017, though things are changing rapidly early in 2018.

What is the Fed’s position on inflation and interest rates?

As recently as last October, Fed Chair Yellen had this to say about inflation: “My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year. Most of my colleagues on the FOMC agree.” We expect the Fed to tread thoughtfully and, of course, consistently with this stance in 2018, raising rates gradually and with a high level of transparency. The Fed’s latest projection is for three rate hikes this year.

We see steady upward pressure on inflation and believe that bond markets continue to underestimate it. The Fed’s preferred measure of inflation, the Core PCE Deflator, is running at 1.6%. The U.S. unemployment rate is a low 4.1%, which, compounded by the fact that wage growth is running at 2.7% and seemingly accelerating, is yet another thrust toward higher inflation. In early January Walmart raised its starting wage from $10 for trained employees to $11. As you can tell, slowly and surely the evidence for stronger inflation is mounting.

How is the fixed-income portfolio structured to account for these market and macroeconomic forces?

We are patient investors with a medium-term focus, and our fixed-income portfolios are definitely constructed with this mandate in mind. These portfolios own shorter-maturity bonds than their respective benchmarks. This enables them to outperform, protecting capital as inflation picks up and rates rise, which lowers the price of fixed-income instruments. Our corporate bond portfolio is structured to be of a very high quality, offering additional protection against rising rates and the potential risk of credit events.

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