Highlights:
· Global economic growth continues, but the surprising absence of inflation is causing hesitation among central bankers to aggressively raise short-term interest rates.
· Wage growth continues to be the missing ingredient in an otherwise strong job market.
· A strengthening Eurozone economy is joining the U.S. economy in helping to drive global growth.
· Japan is in the midst of its longest economic expansion in over a decade, but inflation continues to hover near zero.
· China’s economy continues to grow at healthy rates, but headwinds persist that will challenge efforts to manage a slowdown in growth while deepening ties to the global markets.
Commentary:
Low inflation, moderate economic growth, strong corporate earnings and cautious central banks continued to be the major ingredients in the recipe for the achievement of record-high stock prices in the third quarter. Shrugging off political risks, the world’s major economies are growing in sync for the first time in a decade. Yet what was once thought to be economic growth’s inevitable sidekick, inflation, remains puzzlingly absent. However, as the second longest bull market ever continues, elevated geo-political tensions, and hurricane-related disruptions to the economy, as well as signals that the Federal Reserve will raise interest rates and wind down its unprecedented asset-purchase program, indicate that investors should be bracing themselves for increased volatility and some level of pullback in the near to intermediate future.
Overseas demand is helping to keep earnings for U.S. companies at healthy levels and domestic stock prices remain near record highs. Larger companies with a sizable presence overseas have helped fuel the domestic rally. Low inflation and global growth could be necessary to keep U.S. stocks climbing as the U.S. economic expansion is showing signs of stalling and optimism about a pro-growth fiscal policy has waned. The prospect of U.S. tax legislation is likely to garner a lot of attention in the coming months, but the ability to get a major overhaul done with a divided Republican party and almost certain resistance from the Democrats has many Republicans concerned the tax bill will follow the attempted Obamacare repeal to the legislative ash heap. The equity markets have shot upwards in the aftermath of proposed tax cuts, so it would be reasonable to expect that failure to pass significant tax reform could have negative short-term consequences for the equity markets.
Sluggish wage growth continues to stand out as the Achilles’ heel of an otherwise sturdy U.S. job market. It has been more than eight years since the recession ended and the economy is almost at full employment, yet a sustained pickup in paychecks remains elusive. Globalization, technological innovation, demographic change and the lingering hangover from the recession that saw millions of Americans put out of work are likely all trends that factor in to this lack of wage growth.
Higher wages would typically bolster household consumption, the biggest part of the U.S. economy, and accelerate growth. This, in turn, would likely boost profits and give companies less reason to be stingy with employee compensation in the first place.
The lack of wage growth, coupled with stubbornly low inflation, are likely the primary reasons why the U.S. Federal Reserve has recently struck a more cautionary tone about future increases to short-term interest rates, indicating that the path of interest rate increases will depend on how the economy behaves. The most recent reading of U.S. consumer prices showed a 1.4% year-over-year increase, which is well below the Fed’s 2% target. On the other hand, the Fed showed no hesitation in committing to reducing the bonds they own at a pace of $10 billion a month and increasing that pace by $10 billion every three months to a maximum pace of $50 billion a month or a whopping $600 billion a year. This unwinding of the Fed’s balance sheet is likely to be a multiyear process that will have a significant impact on markets and is likely to result in bond yields continuing to drift higher.
Rising bond yields could adversely impact equity market returns in the short-to-intermediate term as investors would typically have a propensity to return to cash and bonds as yield rise. To this point, however, stock markets have been relatively confident that rising bond yields are simply a result of central bankers responding to stronger economies globally. It would be different if growth were seen as uncertain, as was the case in 2013 during the Fed-induced “temper tantrum” that saw yields shoot higher and equity markets lower over the course of four months. Fortunately, it seems that from the “temper tantrum” event, central bankers learned the importance of clearly communicating intentions to limit uncertainty and allow bond yields to settle down and enable looser financial conditions. In this manner, rising bond yields that reflect stronger economic growth would hopefully have less of a propensity to adversely impact short-to-intermediate term equity market returns, but this remains a significant risk nevertheless.
While the U.S. Federal Reserve has slowly been raising short-term interest rates for almost two years, the European Central Bank is just now nearing the point where it can ease up on economic stimulus and the Bank of Japan is still nowhere near paring back. Like the U.S. Federal Reserve, both the European Central Bank and Bank of Japan have indicated that weak inflation readings could keep them from moving too rapidly despite other clear indicators that economic growth is picking up. Meanwhile, China continues to balance its growth objectives against the need to rein in excessive credit and an overheating property market.
The Eurozone economic expansion continues to be solid and broad-based across countries and sectors. Growth is on the upswing, economic confidence nearing a decade high and the unemployment rate falling to its lowest level in more than eight years, but, much like the U.S., wage growth remains elusive and the annual rate of inflation remains stuck at 1.5%. Nevertheless, the acceleration in the Eurozone’s recovery means it is playing a more equal role with the U.S. in driving global growth. ECB President Mario Draghi continues to indicate that the ECB will be persistent with monetary policy in the face of weak inflation.
The current economic recovery taking hold in Japan has been spurred by its central bank’s ultra-loose monetary policy and the burgeoning recovery that has been taking place around the globe. Both business and consumer spending have rebounded, a weaker currency has made Japanese exports more competitive abroad and stimulus from the Bank of Japan continues to support Japanese stocks, where the Nikkei 225 is currently at levels last seen in 1996. However, while Japan finds itself in the midst of its longest economic expansion since 2006, inflation continues to hover around zero as it has for most of the last two decades.
China’s economy continues to chug along and is on pace to meet its annual growth target of about 6.5%. However, the growth outlook looks murkier when considering the property market’s outsized role in the economy, skittish consumers and signs that significant deleveraging hasn’t fully set in. Recent data show that consumers aren’t spending as fast as their wages, possibly suggesting that many Chinese consumers have become more financially strapped because of high property prices. Elsewhere, the pace of industrial output, retail and housing sales, and investment growth all show signs of decelerating. A recent surge in the value of the yuan further stands to complicate China’s efforts to simultaneously manage a slowdown in growth while deepening its ties to global markets.
As always, we make no predictions as to the impact that current economic conditions will have on future equity market returns. The mere duration of this current bull market suggests that at some point there will be an inevitable pullback or correction in the equity markets. Equity markets continue to be predictably unpredictable, as we are now more than eight years in to an equity market rally that began in early 2009 upon the heels of a near collapse of our financial system. Thus, we cannot know when and how the next equity market corrections around the globe may manifest themselves. We do know they are inevitable, however, and also that sometimes such corrections can be extreme. Beyond appropriately balancing and diversifying the portfolio, we know of no other way to effectively deal with this uncertainty.
To paraphrase Winston Churchill, buy and hold is the worst investment strategy, except for all the others. Being a long-term investor is relatively easy when things are going up, but provides much of its benefit during difficult downturns as well by ensuring participation in the following recovery as effectively as possible. It can be emotionally challenging during difficult periods but most often offers the reward of substantial accumulation of wealth over time. We attempt to consistently and emphatically stress that equity markets are inherently volatile and prone to periods where they decline, sometimes significantly. Beyond efficiently diversifying your equity component, insulating your portfolio with appropriate amounts of cash and fixed income exposure based on anticipated withdrawal requirements continues to be our suggested investment policy for living through the inevitable periods where equities may weaken. Positioning your portfolio in this manner allows you to avoid selling equities at inopportune times, which should result in a return premium vis-à-vis a low risk rate of return over most long-term market cycles.
Urban Financial Advisory Corporation - October 2017