Growth Ahead, Monetary Questions Remain

  • Synchronized global growth continues as expansion enters 9th year after the Financial Crisis
  • Central Banks own $11 trillion of government bonds, mortgage debt and corporate bonds
  • Monetary stimulus will end and tightening begins in 2019
  • Fundamentals should determine investment decisions and personal circumstances govern asset allocations

With the end of 2017, we can look back over the past nine years and take stock of how the world has fared. Memories of the 2008-2009 Great Recession are still quite vivid for some, but for many more, enough time has passed that fear has yielded to participation in the bull market. For those investors who have benefitted from the strong equity markets, the question now is “When will we experience the next recession and its bear-market partner?” For those investors who avoided equities for the safety of bonds, the question some of them ask in addition to the first question is “Is it too late to buy stocks?”

The past year brought us closer to being able to normalize some of the economic and monetary conditions that the world has been living with for the past nine years. It took those nine years and $11 trillion in central bank stimulus, but growth in the equity markets and profits are finally picking up in a synchronized way across multiple regions. For much of the past year, the news has been focused on domestic and international political risks. Investors focused on profits, inflation, P/E multiples, employment and capital spending. Many, if not most, of the geopolitical fears did not materialize, and we suspect that 2018 could follow a similar pattern. Most financial market prognosticators see little on the horizon which could derail the global bull market—at least for the next few quarters. Equity markets continue to climb the proverbial “wall of worry,” but everyone is wondering how close we are to the top of that wall.

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This bullish forecast has been reinforced by the passage of the corporate tax reform bill at the end of 2017. Federal taxes on corporate income will decline from 35% to 21% starting this year. The United States goes from the least competitive corporate tax rate in the G20 to the 5th lowest rate amongst the largest economies in the world (see accompanying chart). It should be noted also that almost all of the countries with lower rates, including Russia, Turkey, and Saudi Arabia are far less “free” than the United States. Tax reform should be extremely stimulative to both the economy and corporate earnings.

At some point, we will have another recession which will almost certainly result in a bear market. However, for the moment, financial conditions are strong, but admittedly financial assets are expensive after years of negative real interest rates. Europe has navigated most of its political land mines and the U.S. Federal Reserve’s leadership has successfully transitioned to Jerome Powell. The U.S. still dominates global markets and is further advanced in its cycle than other economies which means that most scenarios for 2018 are likely to be driven by the U.S. By April, this will be the second-oldest U.S. economic expansion on record. The Business Cycle Index model puts the probability of a recession in the next 12 months at around 25%, a slightly high number but not alarmingly high given the age of the expansion. Offsetting this recovery’s age factor is the fact that this expansion has also been one of the most anemic on record. While a recession at some point is a certainty, it is very unlikely that it will be anything like that of 2008- 09. A simple cooling of risk appetite and animal spirits will suffice.

The big issue for 2018 is the process by which central banks reduce their balance sheets after accumulating more than $11 trillion in government, agency and corporate bonds since 2009. The Big 4 central banks (U.S. Federal Reserve, Bank of England, European Central Bank and Bank of Japan) now own 20% to 40% of their respective country’s government bonds. While the end of the past decade’s grand monetary experiment is now at hand, it is likely that 2018 will still be a year of net central bank accumulation, and when the runoff begins, it will occur over a prolonged period of time. This gradual run-off means that interest rates, especially longer-term rates, will remain low. The Fed currently is the only central bank allowing securities to roll off its balance sheet. The ECB should be able to begin the roll-off process in 2019, but the BOJ and Bank of England will let then current circumstances determine balance sheet size.

After raising short term rates three times in 2017, the Fed has signaled that it intends to raise them three more times in 2018. However, the markets do not expect a similar path of tightening from either the ECB or Japan. The central banks’ normalization of monetary policy— trying to get inflation and interest rates back to higher levels —is fraught with uncertainty, and there are many variables that must be balanced as the process unfolds. The slow monetary withdrawal could be upset by a faster-than- expected return of inflation. While consumer price inflation in the developed world is still below central bank targets, excess capacity in the U.S. and Europe has been shrinking and is now closer to normal. The employment statistics also suggest that wage inflation may soon accelerate. The U.S. appears to be at or above “full employment.” In Europe, wage inflation pressures are building: compensation per employee is rising in France despite an unemployment rate of almost 10%, and one of Germany’s most  influential unions asked for a 6% pay raise. Finally, the deflationary impact of the technology sector is not necessarily a permanent fixture against rising prices.

One final comment on another piece to this puzzle of central bank interventions. Clearly central bankers needed to take dramatic actions to stave off a complete meltdown of the financial systems during the 2008-09 crisis. Actions were taken which had never been tried before and bankers couldn’t worry at the time about any unintended consequences. However, now they have the time to move more slowly and adjust their actions depending upon prevailing conditions. Corporate and consumer balance sheets are in substantially better shape than 10 years ago, and regulations are in place to prevent some of the excesses of the past. Nevertheless, the world must deal with very low interest rates for probably another decade at least. Central bankers’ actions did create distortions in the financial markets which investors are still dealing with today. Examples include negative government bond yields in Europe and Japan (about $4.9 trillion of bonds in total) and the fact that well more than half of European and Italian high yield bonds trade tighter than US Treasury yields. While US Treasury yields are not negative, their decline has created distortions as well, such as foundations needing to take on much higher levels of risk to meet their 5% minimum distribution requirements and retirees needing to invest more aggressively than they might desire in order to earn a meaningful return.

In summary, the U.S. along with the rest of the world is moving toward normalizing their economies and the broad strengthening recovery will go a long way to aiding this effort. However, unlike past recoveries, this one is closely tied to trillions of monetary stimulus. 2018 will probably be the last year in the cycle with rising growth, rising profits and accommodative central banks. Wage inflation will eventually force the Fed and ECB to eliminate negative real policy rates which will create modest headwinds for growth and valuations by 2019. Company earnings should continue to grow for the next several quarters at least, but asset valuations might begin to slip by year-end. As we look toward 2019/2020, the landscape gets more complicated, but not necessarily more dire. Over the past two years, the global supply of equities has been flat. This reflects a combination of factors: fewer new listings, more stock buybacks and M&A, and more reliance on debt by companies due to low interest rates. As central bank balance sheets shrink and interest rates rise, we could see companies return to the equity markets. Our answer to the original questions in the first paragraph is to stay the course; set asset allocations and risk tolerances based on long term planning, not short-term fear or greed. Equities are long term investments for growth; bonds are generally for income and safety. A recession is a certainty, but nobody knows when the economy will stagnate. Corporate America is much stronger than it has been in decades and companies continue to focus on growth, profitability and strong corporate governance. Assets invested in equities should focus on “Will the business grow and prosper over the long term?” not “What can I sell this for today?” Assets invested in bonds should focus on “How safe is this investment?” and “Am I being paid a fair interest rate?” Unexpected events will always surprise investors. Having a well thought out plan to fall back on when surprises occur allows an investor to remain calm in the midst of the storm.