Goldilocks and the Three Fears
It is hard to say with certainty what drives trading on any particular day, but it doesn’t seem a stretch to say that over the past few months a combination of tariffs and Federal Reserve rate hike fears have broadly impacted both equity and fixed income markets. However, while one could say that these two fears have impacted the relative returns of various markets, their actual impact on economic growth in our estimation remains negligible at most.
Trade Fears Narrow
Indeed, as our Q2 2018 Market Commentary detailed, the second quarter ended and the third quarter began with trade uncertainty running high but economic growth remaining robust. While our overall description of the U.S. economy has been upgraded to that of “Goldilocks” (robust economic growth but moderating inflation), we believe that overall trade policy has lessened as we enter the final quarter of 2018. This comment came to a head on the last day of the third quarter when the U.S., Mexico and Canada announced the successful conclusion to a framework for moving forward with the North American Free Trade Agreement (NAFTA)’s replacement, the United States–Mexico–Canada Agreement, or USMCA.
This is a very important development with regard to overall economic and market risk. We have moved from a broad worry that was based upon a global trade war that engaged many countries to one that is gradually narrowing to a spat between the U.S. and China. In other words, Canada and Mexico are the second and third largest U.S. trading partners with total 2017 trade (imports and exports) of $535 and $520 billion, respectively. Importantly, we also note that the U.S. and its sixth largest trade partner, South Korea, have agreed to a new trade deal. And during the third quarter, the U.S. and its fourth and fifth largest trading partners, the eurozone and Japan, agreed on basic frameworks that will set the tone for future trade negotiations.
While there will be future short-term back-and-forths that will drive daily trading, we continue to operate within our intermediate-term framework that these tariffs are not large enough to sink economic growth, and that negotiated paths forward will occur.
Federal Reserve Fears
The other major happening during the quarter was the Federal Reserve tightening monetary policy for the third time this year and the eighth time since late 2015. These policy tightenings have pushed real interest rates (Fed funds rate minus inflation) into positive on nearly all inflationary measures, which has stoked market fears that the Federal Reserve is risking tightening the U.S. into a recession.
Allow us to disagree on two points:
1) While real rates are now (barely) positive, this is hardly restrictive by historical standards. We remind that during past economic cycles, the real Fed funds rate climbed to somewhere between 2 percent and 5 percent before monetary policy became restrictive and helped conspire to throttle economic growth. Much like every other economic data point during this cycle, the question now is whether the math is “different this time.” While much debate revolves around what level is restrictive, let us cast our vote that we don’t believe this time is THAT different. Therefore, we don’t believe we are there yet.
2) More importantly, we believe the Federal Reserve will continue tightening with a velvet touch as they, too, attempt to figure out how much tightening is too much. One could argue that prior Fed policymakers attempted to get in front of future inflation and tightened pre-emptively based upon economic theories. We believe this Federal Reserve cares less about economic theories and pays more heed to actual incoming data (especially those of the inflationary stripes). In fact, we believe that the Fed’s primary focus has shifted on a secular basis. After the Great Inflation of the late 1970s/early 1980s, the Fed was laser-focused on not letting the inflation bogeyman out of the bag at all costs, even if it meant potentially sacrificing additional future economic and employment growth. For much of the past 20+ years, inflation has been very well-behaved; rather, we have had bouts of disinflation that have led to fears of outright deflation, not to mention weak overall economic growth. After the Great Recession of 2007-2009, we believe that the Federal Reserve’s enemy has shifted. Now the central banks desire more economic and employment growth – even if it risks future inflation.
The bottom line remains that we expect the Fed to tighten with extreme care. Put differently: While the Fed has a 2 percent inflation target, we believe there is a large tolerance band to the inflation upside before the Fed would even contemplate raising rates more aggressively.
2020 Recession Fears
While inflation has recently climbed back to the 2 percent target, we believe that “economic help” may be on the way to keep it within the Fed’s tolerance band. This has the potential to extend the economic cycle past 2020, which has become the current economist consensus date for the next recession. We believe this forecast is a “logic-driven call” based upon a simple exercise of looking at how long it will take the U.S. economy to ground to a halt from current levels of economic momentum. Put differently, if nothing changes economically, this is how long it will take for gravity to pull the U.S. economy back to zero.
We believe that this analysis may fall short given that we contend one economic variable is likely to finally arrive after being absent for so many years. That variable is productivity. If productivity growth rises, this means that we can keep inflation well within the Fed’s bands of acceptability over the coming years. And given that we believe the Fed gets to put the final stake in every economic cycle by raising rates, we think this adds up to the potential for a longer economic cycle than the consensus outlook.
For sake of simplicity, let’s define “inflation” as a condition in which current demand exceeds current supply. When we run out capacity to create supply but demand stays strong, prices (inflation) rise. And let’s define “potential supply” as how many people we can get to work multiplied by how productive they are. While corporations continue to find over 200,000 new workers to hire each month, we acknowledge that at 3.7 percent unemployment, the pool of available workers is shrinking. Returning to our supply formula, if the number of workers is shrinking, we are going to need a way to increase their output per hour to get increased supply – and output per hour is determined by the economic variable called productivity.
How do we increase productivity? While productivity is notoriously hard to predict, if you look historically, it has a strong relationship with business fixed investment. Following the Great Recession, business fixed investment has remained incredibly weak as corporations have had access to relatively cheap labor to create supply. Now, with labor running short and businesses flush with cash, we believe that business fixed investment is likely to grow. And we note that over the past few quarters this is exactly what happened.
We believe that if productivity growth continues, inflation will remain constrained and the Federal Reserve can continue holding rates in accommodative territory to help keep the economy moving higher. And as we are apt to say, if the economy pushes higher, the equity market is more often than not pulled higher with it.
From Fear of Missing Out to Fear of Being the Last In …
While different measures give you slightly different answers, based upon one such definition during the third quarter the U.S. Equity market notched its longest bull market ever. As you might imagine, this has led many to worry that a bear market is imminent, no matter what our economic outlook above suggests. This fear is now the greatest reason many cite as a reason to not invest. The fear of missing out on future market returns has now morphed into the fear of being the last one in before the market collapses. While no historical time period provides an exact road map for the future, we believe that the past 11 years provide a real-life example of how asset allocation and portfolio construction can help soothe these worries.
Let’s pretend you are reading this in October 2007 instead of October 2018. Specifically, let’s pretend today is October 9, 2007, and this article compels you to invest in the stock market. Why is this date important, you ask? Because this was the day the U.S. Equity market (S&P 500) peaked before the Great Recession began rearing its ugly head a month and a half later. What would have happened to your portfolios of stocks? Unfortunately, between October 9, 2007, and the depths of the Great Recession despair on March 9, 2009, your portfolio of U.S. equities would’ve declined by nearly 55 percent. However, if you would have resisted the urge or were not forced to sell to fund cash needs, your portfolio would’ve climbed back to even on a permanent basis by November 2012. And by the end of the third quarter of 2018, it would have more than doubled, up 136 percent cumulatively (or 8.12 percent per year).
Whether you are apt to agree with our forecast, I hope that no one reading this commentary is looking to buy stocks today that they plan or need to sell within 18 months (or even five years) but rather are buying them for longer time horizons such as 10 years. If you need money in the nearer term, bonds and cash should be used.
While “noise” often drives stocks and bonds on a daily basis, it is important to stay focused on longer-term investing strategies and asset allocation.