Rationalizing Uncomfortable Choices

Q3 Investment Outlook:      

• Equities should outperform bonds by 5-7% over the next year as Treasury yields rise toward 2.5% and interest rates are hiked at least twice in 2016. Global equity returns exceeding 5-7% will be more difficult with valuations closer to normal now. Moderate economic growth isn’t exciting, but remains sufficient for economies with still resilient profit margins and productivity. Despite June’s equity volatility, our global tactical equity models remain constructive and imply at least 7% returns over the next year. Transitory effects of plunging oil prices and U.S. dollar appreciation that gutted energy sector earnings and undermined CPI inflation are underappreciated, but the impact of these effects is sunsetting now.
• Global bond markets are significantly overvalued with negative real yields, particularly in the U.S. and U.K. where economic growth is better and inflation is increasing. Negative interest rates for German Bunds and Japanese Bonds can’t be sustained, well below 2009 lows even as inflation firms. We recommend underweighting bonds, overweighting cash, and minimizing interest rate sensitivity, favoring shorter maturities and floating rate securities.
• Fears of slowing global economic growth remain high. Business owners have adapted well for seven years, but new business formations have plunged nearly a third since 2008. Companies are struggling to find new ways to innovate, needed to overcome rising overhead and regulatory costs, and efficiency gains needed to maintain productivity seem to be running out. Financial reform has slowed corporate lending, while notably restraining trading liquidity of both equities and bonds. The global economy expanded 3.1% in 2015 and can accelerate in 2016 on the heels of stronger growth in the North America, Europe, Australia, India, and others. Declining global trade seems to have troughed, but reversing fiscal austerity helps too.
• Strong evidence suggests that innovation and application of technology have boosted profit margins, thus earnings growth, despite moderate economic growth and low measured productivity. Demographics, evolving skill requirements, and process efficiency gains have limited job growth, but labor markets will adapt---it just takes time. Labor productivity became less cyclical as labor intensity declined. Low wage countries that benefited from globalization have stalled with increasing automation, robotics utilization, and machine learning—profit margins collapsed as wages rose dramatically.

• The extended period of explicitly manipulating interest rates has induced moral hazard for investors, businesses, and households for an extended period. Interest rates need to normalize, particularly given unconventional excessive central bank holdings globally. Treasury bond yields need to rise 3% just to get back to when the Federal Reserve last started to hike rates in 2004. It is incredible to compare the current yield curve to 2004 and during the Financial Crisis in 2008, or even the average yield curve over the last 50 years. Investors need to be vigilant about the impact of rising U.S. rates on global bonds and other rate sensitive investments. Emergency monetary policy is no longer needed. Treasury 10-year bond yields need to rise above 5% to normalize vs. normal inflation, while steady interest rate hikes proceed with every other meeting or 1% per year.

• While some investors suggest low interest rates and flatter yield curves are a sign that economic growth is slowing or slipping into recession, these relationships are misleading. Global imbalances due to central bank interventions persisted over an extended period and must correct. Financial reform of market makers has intensified fixed income illiquidity risk, which is difficult to measure.

• Waiting for valuation corrections is uncomfortable, such as waiting for equities to correct in 1999-2001, but patient investors should be rewarded. We underestimated the effects of foreign demand for Treasuries, expecting yields to rise this year, not fall. Instead, imbalances increased with continued explicit central bank manipulation of market prices, which drove global 10-year yields below 2008 crisis levels, including unprecedented negative bond yields in Europe and Japan. Hedging currency risk is an easier decision as long as European and Japanese central banks continue quantitative easing. Repricing global bonds presents the greatest danger to the world economy, exacerbated by illiquidity risks.

• Britain voted to Leave the European Union (EU) after over 40 years. It is a remarkable decision worth taking the time to understand why membership in the EU Common Market no longer served their best interests. This decision has little near-term economic impact, but reflects anxiety about underperforming economic potential. Our outlook is distinct from consensus—we are more constructive about the U.K becoming unshackled from uncompetitive regulation and misguided policies. Potential growth should benefit from improved competitiveness and reduced regulatory overhead, attracting foreign investment.

• Alternative strategic asset allocation policies have lagged traditional balanced strategies. Historically derived asset class volatility and correlation are evolving and unstable, suggesting risk-focused methodologies can yield inefficient investment policy allocations. If the next crisis is rooted in sovereign debt, aggravated by expanding fiscal deficits adding to debt, plan funding risk is higher than assumed. Gold is a terrible strategic allocation and tactically undesirable as a hedge when inflation is low with higher volatility than equity indices and low but positive correlation with stocks—cash is a better store of value, particularly with a strong U.S. dollar.

• In Rationalizing Uncomfortable Choices , the list of pivotal investment questions is longer than ever, but we should begin with minimizing unforced errors and unintended risks. It should begin with how to minimize unintended risks, anticipate consequences of higher bond yields, while improving estimates of evolving asset class volatility and correlation measures. Relative asset class valuations are critically important to consider, as well. Economic uncertainty has increased, and asset owners are presented with many unfamiliar new products that seem appealing, but with limited real-time experience. Structural relationships can change, but “it’s different this time” typically never works out well.