2018 Quarter #3
Given the combination of (1) stable but slowing global economic growth; (2) sensible monetary policy support by central banks in the U.S., Europe and Japan; and (3) moderately rising inflation, our portfolio positioning favors a “neutral” approach, balanced between equities, real asset alternatives and fixed income with the following expectations:
• Long-term expected returns for all asset classes may be below returns experienced over the last 10 years; however, returns for equities could be well above those for fixed income for some time with higher volatility compared to the previous two years.
• Several exogenous threats (the biggest of which include a Federal Reserve Bank monetary policy misstep, tariff policy changes/trade wars, and a rising risk of a global economic slowdown) could unsettle capital markets at any time, resulting in higher volatility than recently experienced.
• U.S. equity valuations are relatively expensive, versus foreign-developed and emerging-market equity, and can experience market corrections at any time.
• Alternatives should offer low-correlation inflation protection and differentiated returns compared to equity and fixed income.
• Fixed income investments are prudent given potentially rising bouts of volatility.
• Assuming your plan, risk tolerance and investment policy are aligned, long-term investors need not take drastic action.
Economic growth in the U.S. continues surfing the wave of President Trump’s pro-growth and business-friendly fiscal stimuli, which has come in the form of lower taxes and reduced regulatory burden. However, it seems the swell is at risk of losing its “oomph” for two reasons.
The first is the protectionist trade agenda of Trumponomics. This past quarter import tariffs were introduced by the U.S. and, in retaliation, by U.S. trading partners. We continue to monitor the ongoing dialogue surrounding tariffs and the international trade arena carefully. If all-out trade wars breakout, lower economic activity and upward pressure on inflation have the potential to derail the global business cycle expansion.
Interestingly, while some believe running a trade deficit means other countries are stealing U.S. jobs and wealth, reviewing historical data proves otherwise: rising U.S. economic growth tends to increase imports through higher U.S. consumption. A trade deficit is actually the sign of a strong U.S. economy.
Furthermore understanding the type of goods the U.S. imports is critically important. Most imports into the U.S. are not “final” or “finished” goods but, rather, “intermediate” goods. These are inputs used to make American products, which then can be sold to U.S. consumers or exported out of the U.S. Tariffs increase the costs of these inputs and can harm U.S. industrial competitiveness.
The second threat to economic growth is the Federal Reserve Bank. After raising short-term interest rates seven times since December 2015, the Fed still believes it has a green light to tighten even more, which we expect it will do soon. Recall, the Fed does not have a good track record raising interest rates and avoiding recessions. Their actions usually end in recessions, and we believe it will happen again.
As a result of all this, it is not surprising to see that the “second derivative” or “rate-of-change” of several high-powered leading economic indicators has declined meaningfully since the beginning of the year. This may be signaling a potential economic slowdown late this year and into 2019. This would be consistent with economic growth momentum peaking in the first half of 2018 and positive (but slower) economic growth coming our way next year.
Such economic momentum peaks in the past tend to be associated with a temporary corrective backdrop for global equities, fixed income rallies and outperformance by interest-rate sensitive, defensive sectors such as real asset alternatives.
While we do not expect an imminent recession, an informed radar screen of leading economic indicators is helpful because bear markets (sustained stock market declines of 20% or more) coincide with recessions based on our study of business cycles over the last 100 years. All said, our educated guess is the risk of recession in the next 12 months is still low (although up from last quarter) despite this business cycle expansion being the second longest since 1900. However, further upside in global equities from current levels seems more challenging compared to previous years, and our shift to a more neutral portfolio positioning now seems appropriate.
The portfolio profiles outlined above may vary based on the individual investment objectives of your financial plan. As always, we very much appreciate and value the trust and confidence you place in our firm. Please do not hesitate to contact your advisor with any questions or service needs.
Contact our Chief Investment Officer, Russell Moenich to learn more about this topic.
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