Outlook — something’s gotta give
With improving economic data, supportive fiscal policy (tax reform complete and an infrastructure package supposedly on the way) and benign monetary policy, 2018 appears healthy for markets of all stripes. Yet, as noted, if inflation remains stubbornly low and other exogenous trends persist, then interest rates are unlikely to shift meaningfully higher.
This poses an interesting dilemma: are we closer to the end of business cycle than to the start of a transition higher in rates? Janet Yellen observed that “it’s a myth that expansions die of old age,” but prior to Trump’s election, the current business cycle appeared to be in senescence. The recent reinvigoration enabled the Fed to step back as it has, but it chose a deliberately slow path. The balance sheet unwind will take years to meaningfully reduce the Fed’s exposure, which raises the question if the Fed is “all in” on the cycle continuing.
Should we experience a hiccup, a pause in the unwind is likely, but what of a full blown recession? Do markets now expect quantitative easing as a response? The end of a business cycle is different than a financial crisis, but are investors prepared to make the distinction if equity markets decline beyond correction territory?
Rates — the odd man out?
At least in the short term, the Fed’s bet of a positive economic horizon appears reasonable. They should be able to continue reducing their balance sheet and increasing the Fed Funds rate. Balancing the various demand factors, rates should close the year higher, but not dramatically so. If this is the case, it is important to restate some of the experience of 2017. At various points, rates had risen meaningfully over the trailing 12 months, yet fixed income returns remained positive if unexciting. With rates currently at a higher starting point than, say, the third quarter of 2016, interest income provides a greater cushion.
Interest rate markets appear to be the odd man out compared to other asset classes. In our view, the stubbornness of interest rates to get onboard with other asset classes represents the bond markets typical — and healthy — skepticism, which serves as a reminder: While asset prices are flying high, multiples are expanding and blockchain technology is providing yet another “asset class” for risk markets, GDP of mid-2%s and core inflation of mid-1%s provide nearly no margin for error when it comes to “policy normalisation.”
This is the classic, “half full vs. half empty” debate, whereby risk markets are looking at the next 6 to 12 months as a period of stable to increasing growth, which will see its way through any additional policy normalisation. Economic data and financial conditions have been steadily improving along with the Fed’s slow drift towards higher interest rates. On the other hand, the Treasury market remain unconvinced that the next chapter of this expansion is the one in which real wage growth finally accelerates and the much-discussed Phillips curve is fully redeemed. After all, if the neutral rate for Fed Funds has shifted lower, theoretically so too must the neutral unemployment rate. If that is in fact what the Treasury market is telling us, it is a view the Fed does not appear to share. The Fed believes the pedal has been pressed to the metal long enough, and the car is finally going to be dropped in gear. This point of contention is one that will not be resolved until the Fed telegraphs policy is now “normal,” perhaps 12 to 24 months from now.
As we synthesize all these factors, we see a benign environment for traditional fixed income, one no doubt with unforeseen surprises, but one that delivers reasonable returns even if yields drift higher. With changes abounding from fiscal and monetary policy, nimbleness will be at a premium.
In the current market phase of high liquidity, insatiate investor appetite for risk, and ample market demand for new securities and low to negative yields on cash, asset prices have been rising across the board. As such, the risks are asymmetric to price declines, yet few factors are visible catalysts to drive such declines at the moment; on the contrary, there are ample arguments to support current levels of pricing or further improvement. In our view, this is as true of private equity, which saw record capital raises in 2017 (over $450 billion) and dry powder accumulate to over $1 trillion for the first time, as it is of corporate bond spreads at their tightest levels in a decade. While we are therefore cognizant of fixed income valuation levels, we view these investments in the context of a world where nothing appears cheap.
Leaving aside our general view that liquidity is a nearly permanently undervalued risk factor, it is noteworthy that some investors are seeking speculative gains from their cash in form of cryptocurrency. This choice of private currency vs. standard currency is similar to the liquidity trade-offs we are witnessing from equity vs. private equity to traditional fixed income vs. private debt and other non-traditional fixed income alternatives. The promise of returns is tantalising, but the liquidity give-up, substitution of risk factors and lack of historical testing are less appealing. In periods of market illiquidity, the aphorism “cash is king” invariably resurfaces, though it often lays dormant in intervening periods. We appear to be in such a hibernation period, a healthy reminder that when the liquidity of traditional asset classes is needed vs. less liquid alternatives, it is harder to find.
With secular trends speeding ever faster and fears of obsolescence touching new sectors and businesses, deep research will be as important as ever in investment decisions. While it can be tempting to believe that a new technology, investment approach or cryptocurrency will remake the world and offer us a panacea, more often we find that it is the same boring old fundamentals that guide us best for the long term.