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Thursday, January 19, 2017
Is This the Beginning or the End?
Investment Strategy | January 2017
Director, Investment Research | Consulting Research Group
The deflationary forces that dominated the last eight years led to a period of prolonged economic stagnation. Then, just as the global economy appeared ready to reemerge, geopolitical change shook the world.
Is the U.S. business cycle primed to continue with the tailwinds of new policy and a stabilizing global economy powering it higher? Or will new geopolitical and policy risks finish it off?
While the world seems more uncertain than ever, this year’s predictions highlight three areas we’ll be watching that should give us some answers. To understand what’s next, it’s important to understand where we’ve been.
A Quick Look in the Rearview Mirror
Starting with the financial crisis, two major deflationary forces were unleashed on the global economy that led to a ten-year deleveraging cycle. It started with the collapse of the U.S. housing market and retrenchment of the consumer, the power behind the U.S. economy. There was a concurrent slowdown in China, the world’s production superpower and factory floor. After years of debt buildup, that economy buckled under the pressure of slower growth and a weaker currency.
It is the damage inflicted by these forces that produced this period of global economic stagnation. Simply put, we have just experienced a period of low growth and low inflation that, if graded, would fall below anyone’s passing score.
The primary response from world leaders was central bank asset purchases, or quantitative easing. They hoped to stimulate their economies with low interest rates and easy money to create demand and lift growth.
These policies powered a strong bull market in bonds and propelled stocks higher. As we enter 2017, the U.S. expansion enters its eighth year, making it the third-longest in post-war history.
Which raises the question: are we nearing the end of the current cycle or is there room to run?
Monetary policy showed its limits in 2016, but we saw signs the global economy was stabilizing. While far from returning to robust growth, it looked like we had finally escaped the deflationary forces in control since the crisis. Fundamentals pointed to higher markets, and investors could justify a longer cycle given the adjustments needed for the financial crisis.
Making the question uncertain though is the populace’s response to secular stagnation. Low growth in the U.S. and abroad has stirred frustration about income inequality and a perceived lack of jobs. Many people have lost faith that their children will enjoy better opportunities than they experienced. The result played out as Brexit, Italy’s “No” vote, and Donald Trump’s election as U.S. president.
These votes show skepticism of the value of globalization and led to a focus on domestic policies that could more immediately impact growth.
The world today is at a turning point. We find ourselves emerging from a prolonged period of debt payback at the time we’ve decided to try something new. Although fundamentals support a positive view on the markets next year, the future seems uncertain and clouded with policy unknowns.
However, while the path may be more uncertain, the strategy is clear. We’ve laid out three key themes that we believe will drive market performance for the next year.
The Great Handoff
It has only been a few months since Donald Trump was elected forty-fifth president of the United States, and markets have responded to expectations of fundamental policy change out of Washington.
Trump’s move toward expansionary fiscal policy is a seismic shift, ringing in a post-monetary-policy era in the U.S. Even just the prospect of this shift has profoundly affected portfolio returns. And this is just the beginning. For investors, this shift in policy marks a major moment and has considerable portfolio planning implications.
While monetary policy has dominated the post-financial-crisis economic landscape, the next few years may flip the script. The combination of expansionary fiscal policy, deregulation, tax reform, and a stabilizing global economy should generate improved growth in the coming year—and also the prospect of higher inflation.
Already the U.S. economy is showing signs of emerging inflation, driven by a tightening job market and rising oil prices. With a boost from more government spending and tax cuts, the flicker of inflation could become a full-on flame.
This means we are leaving a period friendly to stocks and bonds and entering one that could be stock friendly—but may be unfriendly for bonds. Investors should favor stocks over bonds and look to add inflation-resistant assets to portfolios.
We have also seen a regime change occur within the U.S. stock market. Yesterday’s losers have become winners and vice versa in industries from energy to financials to pharmaceuticals. This is a theme that will continue. The past several years’ market leaders—stocks like Amazon, Netflix, and Alphabet (formerly Google)—may struggle to keep up as investors’ preferences change.
We think investors should look for value stocks. Many value sectors receive heavy regulatory scrutiny that may be lifted under the Trump administration. Small-capitalization stocks could also outperform. They, too, bear a higher regulatory burden than their large-capitalization peers.
On balance, the combination of government spending, deregulation, and tax reform should be positive for U.S. stocks in 2017. It could also put a cap on bond market returns. Market leadership change will be a story this year, but inflation could be the biggest story. While modest inflation would be welcome after years of low inflation, flat-to-declining corporate earnings, and low wage growth, a flicker of inflation that turns into a flame could undo many of 2017’s positives.
Geopolitical Risk and a Leaderless World
Up to this point, we’ve talked about potential tailwinds resulting from pro-growth economic policy. While the wave of populist advances that ushered in these policies across the globe may catalyze growth in the short run, it also marks a shift in risk.
If risk over the past ten years was characterized by the potential to fall into a deflationary spiral and another financial crisis, the risks going forward are very different. Today, the primary risks we see affecting markets are the lack of a global leader and an uncertain geopolitical world.
A prominent geopolitical research firm recently wrote that investors often think of the economy in cycles, lasting seven or eight years, but that they don’t think about geopolitical ones. Geopolitical cycles exist too, but they go on much longer, often for decades at a time.
Since World War II, we have been living out a cycle called Pax Americana, a term political scientists use to describe relative peace around the globe. American leadership in trade and security, and the promotion of democratic values define this cycle. President Trump’s “America first” promise marks a clear departure from this cycle’s tone and decades of foreign policy.
We are entering a world where America no longer feels the need to shoulder the burden of world leadership and pursues its interests first. In this world, the leader who has served as the cornerstone for global stability will no longer play that role. When the U.S. pivots away from its leadership role, we will enter a period of uncertainty as political norms and trust forged over the past 70 years fade.
With the U.S. off its watch, we expect emboldened leaders around the globe to pursue opportunities more aggressively in their regions, especially within Asia. Maneuvering from these countries further increases geopolitical uncertainty and risk to markets.
It is unlikely that the world will deteriorate into all-out conflict, but events unthinkable only a few years ago can now be imagined. Geopolitical risk affects business confidence, although that too can take time. Most people are slow to recognize changes in geopolitical cycles, which are much longer. Most likely, the U.S.’s move toward self-interest creates investment, which causes the U.S. to grow and the dollar to further strengthen.
Given the dawning of this new era and a maturing U.S. business cycle, now is not the time to take big risks, but a time to start taking position sizes down. We expect volatility this year driven by geopolitical events and want to ensure we’re able to capitalize on opportunities when they present themselves.
Higher Bull and Higher Bear Cases
Our final prediction for 2017 involves the path of potential outcomes. We are optimistic as the global economy exits eight years of stagnation but see the chance of extreme outcomes, both positive and the negative. Monetary policy exhaustion, a still-fragile world economy, and rising political risk point to a potential overshoot to the downside. Meanwhile, positive economic policy change that leads to a larger sentiment change could unleash investors’ animal spirits and an upside surprise.
In our downside case, we see a number of problems that could unfold for the global economy. The main one involves the policy choices that could reassert the U.S. and attract capital as it returns as a growth opportunity. While this would be positive for U.S. investors and businesses, it would most likely strengthen the dollar.
A strong dollar could literally “break” other economies unable to manage weaker currencies and dollar-denominated debt payments. In this scenario, pressure imposed by U.S. strength could lead to a sharp decline in emerging markets, especially China.
Political uncertainty also looms large in 2017. Notably, China holds its 19th National Congress of the Communist Party in the third quarter. China last held these meetings in 2012. Chinese President Xi Jinping is expected to consolidate power further this year. And he’s going to be sensitive to anything that would create the perception of weakness.
Given the importance of these meetings, we see a chance of a policy overreaction in response to either political or economic volatility, where unnecessary steps are taken to ensure perceived stability and authority.
Political uncertainty also exists in Europe this year with French and German elections. The outcome of the French election, in particular, could start the clock on the end of the European Union if the populist wave makes its way to France. The potential for these outcomes to weigh negatively on sentiment figures into our assessment.
On the positive side, there is a path to a larger than expected upside surprise. Years of accommodative policy that pushed up financial asset prices largely never made its way into the economy. These stockpiles of cash sitting at banks could act as kindling, fueling a surge in U.S. growth as banks start to lend and companies begin to invest again.
The U.S. consumer also appears ready to spend and relever after years of retrenchment. This could serve as a positive catalyst. Should business and consumer confidence rise in tandem, we could see a surprisingly positive scenario and a rise in stock prices.
Given the large divergence of outcomes, we believe investors should maintain liquidity and take advantage of opportunities on either side. Active management and selection of managers with specialized expertise will be critical to success in asset classes such as fixed income and U.S. small-cap and international stocks. Lastly, investors should search for uncorrelated areas of return that are not path dependent on either outcome and can make money regardless of the future world state.
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