Third Quarter 2018 Client Newsletter

In our last market update, we discussed the possibility that the market had entered a consolidation phase in an otherwise healthy bull market.  Since then, we’ve seen: the official implementation of tariffs on over $200 billion worth of Chinese imports, another remarkably strong quarter for corporate earnings, interest rates continuing their multi-year uptrend, and energy prices that are beginning to spike.  Yet through all the noise, the U.S. market has remained a bright spot versus a group of broadly negative international and fixed-income benchmarks.

In this newsletter we will be discussing the impact of political perception bias on macroeconomic narratives, global growth trends, concerns about emerging market debt burdens and the outlook for monetary policy in the U.S.

Absent a major shift in the market or economic backdrop, this will likely be our final update until year-end.  In the interim, as everybody is aware, mid-term elections will be held.  And as you’d expect, we are getting more frequent questions about the potential market impact.  Some of the concerns we are seeing and hearing from our sources and clients include:  A ramp up in impeachment proceedings, a rollback of corporate tax reform, new burdensome business regulations, and unchecked trade policy.

Each of those potential market negatives will likely be counterbalanced by gridlock between the executive and legislative branches.  Various sources put the odds of Democrats winning a majority in the House of Representatives at roughly 60% and a majority in the Senate at 20%.   Gridlock promises to be frustrating and difficult to watch, but oddly enough, history shows markets have had some of their best years during periods of inaction in Washington.

So even though the political noise will be inescapable, and at times market moving, the most important factors for the market will continue to be the outlook for the economy, earnings and interest rates.  And as we assess these three pillars today, we still see a supportive picture.

Feelings vs. The Economy 

The Economy – a big bold two-word phrase that typically evokes thoughts of decimal points, incomprehensible jargon, and for some, outright fear.  But at its core, when we talk about the economy we’re simply talking about how goods and services are allocated, and whether or not ‘things’ are getting better or worse for citizens and businesses.  The problem with economic data is not (usually) that the data is biased, but rather that the interpretations are made by people, and people, have feelings.  These feelings naturally lead to bias in the way we all perceive data.

As a money manager it’s our job to make sure these natural tendencies for bias are anchored not in emotion, but by the reality of empirical data.  To accomplish this, we monitor leading, coincident and lagging economic data on a global basis.  Among the most revealing short-term indicators of economic activity are business and consumer surveys.  By and large, the survey data in the U.S. is uniformly strong.

For example: Small business optimism as measured by the National Federation of Independent Business has never been higher.  Surveys of purchasing managers conducted by the Institute for Supply Management are signaling a healthy expansion.  Various consumer surveys are also signaling optimism.  

The white line below represents the Consumer Comfort survey conducted by Bloomberg that simply asks a sample of U.S. consumers how confident they are in their current financial position.  And consumers haven’t been this optimistic since the early 2000’s.  

But segment the consumer survey by political affiliation, and you’ll quickly discover two very different levels of financial comfort.  The blue line represents Democrat respondents, and the red line represents Republican respondents.  The separation between the two groups is reflected by the yellow line in the sub-chart.   As you can see, Republicans and Democrats have never had more disparate views on the economy.  The party views go something like this:

• Larry Summers (Treasury Secretary under Bill Clinton) and other prominent liberal economists, believe that the acceleration in the economy is a ‘sugar-high’ from corporate tax reform that is pulling activity forward and will ultimately shorten the cycle.
• Republicans attribute the uptick to the new administration and a business renaissance sparked by deregulation.

One or both could be correct, and we constantly monitor all of the evidence.  But the irony is that this inconsistent outlook is taking place during one of the longest and most consistent economic expansions since World War 2!  

Below is a review of a few major economic data series over the past 4 presidencies (red shading for Republican administrations, blue for Democrats). The arrows indicate whether the data signals an expanding or deteriorating economic picture.

GDP is growing, consumers are spending, new homes are being built, and fewer Americans are looking for jobs.  In fact, each of them have been going the right direction for more than 30 quarters.  And there is little doubt that when these 4 indicators are all expanding, that the economy is on solid footing.

As with most empirical issues clouded by politics, the truth generally lies somewhere in between the extremes.  And in this case, the truth is that the U.S. economy is expanding, and that is a good thing for both Republicans and Democrats.

Going Global

After an above trend year in 2017, companies in the United States are following up with an even stronger one in 2018. Thomson Reuters data indicates more than 20% earnings growth, riding on the backs of more than 8% revenue growth and a tax-cut-fueled boost to profit margins. That blows away projected earnings growth of other developed markets, and even outpaces typically faster-growing emerging markets. In 2019, however, the race narrows. United States earnings are again expected to have an above-trend year of about 10%, but so is developed Europe, and emerging markets are expecting an advance of nearly 12%.

Broadening global strength is a good thing, as progress in other regions can help sustain demand here at home. And while it has been beneficial to ‘stay at home’ for the past 24 months, the relatively low valuation of international equities could present attractive opportunities. Of course, opportunity never travels without its own unique risks.

The summer of 2018 has seen renewed concerns about debt solvency in emerging markets. Favoring its stability, a large portion of debt in developing economies is denominated in (and must be paid back in) U.S. Dollars. Problems arise when foreign currencies fall in value, causing the debt payments to be relatively more expensive for businesses and governments whose cash and revenues are suddenly worth less. According to data from the BIS and IMF, more than $3.6 trillion of U.S. Dollar-denominated debt is outstanding in emerging markets, the equivalent of about 11% of those countries’ combined GDP.

Argentina and Turkey have highlighted, or perhaps lowlighted, the problems emerging markets are facing. Each has seen its currency fall by more than 50% this year as inflation and political turmoil have spooked investors. Moreover, rising interest rates in the United States have created demand for U.S. Dollars and the competitive, risk-free returns they can buy. Funds flowing out of EM haven’t been limited to just those distressed markets. The J.P. Morgan Emerging Market Currency Index, which comprises 10 currencies including the Chinese Yuan, Russian Ruble, Mexican Peso, and Indian Rupee, is down almost 15% since January. Less developed economies often rely on foreign investment to drive growth, but beyond raising local interest rates and potentially hurting their own consumers, foreign officials have few tools with which to fight back. If interest rates continue to rise here at home, there could be more trouble abroad.

Interest Rate Interlude (A Monetary Policy Update)

As many of you know, we have entered a rising interest rate environment defined by the actions set forth by our central bank, the Federal Reserve.  How fast and how far the Fed goes in increasing rates will have a substantial effect on the financial markets.  So where are interest rates headed in 2019 you may ask?  The answer to that question has become less clear because, recently, a divergence has emerged over interest rate path expectations.   

The chart below depicts the median expectation of Federal Open Market Committee participants for the end of 2019 (represented by the green line) and the expectation of market participants trading fed funds futures contracts (represented by the white line).  As of the most recent Federal Reserve meeting, the median expectation for the federal funds rate for year-end 2019 is approximately 3.1%, while market participants’ (represented by fed fund futures) is approximately 2.8%.  In other words, Federal Reserve members are expecting an additional 1 to 2 more rate hikes than the market is currently anticipating.

This divergence in rate hike expectations will have implications for the broader financial markets.   If the Fed is correct in their hypothesis, the size of the divergence could negatively impact emerging markets, many of whom issue dollar denominated debt.  Rising U.S. interest rates are associated with a stronger dollar and a stronger dollar has the potential to make our exports more expensive to foreign buyers.  All else equal, more expensive U.S. exports could result in reduced demand for U.S. products internationally.  Rising interest rates also generally make debt financing more expensive for our domestic companies and results in bonds becoming a more attractive alternative to equities.  

While the Fed’s official dual mandate requires them to balance the tradeoff between domestic unemployment and domestic inflation, the Fed may have to consider the state of emerging markets and even the state of other developed markets in setting monetary policy priorities.  The argument here would be that developments outside of the U.S. could affect the Federal Reserve’s dual mandate inside the U.S.

In 1998, a currency crisis that began in Thailand spread to other Asian economies and eventually to Russia.   Because of the interconnectedness of the global economy, the Greenspan led Federal Reserve was forced to lower interest rates (see below).

If the current Federal Reserve decides to preemptively attempt to avoid a potential emerging market currency crisis, they may decide to slow or pause rate hikes in 2019.  If this pause or slowing of rate hikes were to come to fruition, these developments could bring additional positive news for markets.  

Conclusion

We continue to believe that a backdrop of global growth, strong corporate earnings, historically low interest rates, and reasonable equity valuations warrants a positive outlook.   The major risks to this positive outlook are a trade policy failure, a shift towards aggressively restrictive monetary policy, or indications of pending recession.  We are monitoring developments in each of these key areas and stand ready to adjust our positioning as needed.

Please let us know if you have any questions about our overall strategy or the content of this newsletter.