Rick and Russ argue that the recently enacted U.S. tax cut and an evolving monetary policy backdrop provides both greater clarity on expected increases in volatility and underscores the need to remain flexible and opportunistic in allocation.
In our final blog post of 2017, we argued that the 2018 investment “vintage” would likely be defined by history as marking a cyclical turning point within a much larger secular bull market for global risk assets. We suggested that the ongoing low-volatility, quantitative easing-driven, deflationary boom cycle would likely pivot toward an inherently more volatile fundamental environment. While longer term investment forecasts are by definition opaque, a great deal of clarity has been provided by the events of the past several weeks. Now, in possession of these new and substantive fundamental realities, we are emboldened by our previous prediction, and seek to provide more granularity about our view of 2018’s likely evolution.
Greater clarity with the turn of the year
As 2017 came to a close there were numerous virtuous factors providing a tailwind for risk assets, including about $1.7 trillion of new global liquidity injections during the last three quarters, despite the commencement of Federal Reserve balance sheet runoff. Moreover, accelerating synchronous global growth was basking in the glow of proliferating wealth creation, accelerating wage growth and a deregulatory dawn for the U.S. economy. And then to add to all these tailwinds, with an unexpected swiftness and breadth, came the afterburners of sweeping fiscal stimulus. This cocktail of powerful factors has facilitated an evolution into a new and inherently more volatile cycle that will feature accelerating economic and earnings growth and a nascent rise in inflation.
Indeed, in our estimation, the Tax Cuts and Jobs Act of 2017 is a game changer representing a massive deficit-financed pro-growth shock (see graph). Moreover, Congress seems ready to deliver still greater deficit-financed stimulus with a generous budget deal, and possibly a third layer of infrastructure spending. The immediate positive response from corporate America has been impressive as the transmission mechanism of fiscal stimulus has been expressed with intentions to increase wages and bonuses, repatriate billions of dollar of foreign-domiciled capital, boost investment (capital expenditure and research and development), and bolster shareholder outlays. All of this will likely pull 2020–2021 growth forward, adding as much as 0.75% to annual real gross domestic product growth over the near term, by our estimates, alongside an uptick in cyclical inflation driven by accelerating wage growth. At the same time, this fiscal policy regime change creates tremendous uncertainty about the ways in which these initiatives will be funded down the road, which sows the seeds of rising volatility in coming quarters.
Putting it all together it feels like the paradigm shift we foresaw is playing out in ways that resemble the 1986-87 experience. Then, like now, an ongoing secular bull market was enjoying a deregulatory tailwind, a weak U.S. dollar, a relatively stable interest rate environment, and solid organic real growth that led to a collapsing output gap. In the midst of this demonstrable momentum, the 1986 Tax Reform Act catalyzed a powerful incremental risk rally during the first half of 1987, which eventually gave way to an interval of notably higher rates and historic market volatility. But we’re confident that today’s deeper and more mature financial markets will dictate less volatility than that seen in 1987.