Thoughts from our CIO, Scott Welch…
May 24, 2016
This is an interesting time for the US (and global) economy. You could find an almost infinite number of economists to support either side of the title statement. To say we are in the “uncertain zone” is to understate the current state of affairs and, if anyone tells you they know where we go from here, they are either lying to you or lying to themselves. We will borrow a phrase from John Mauldin and suggest that we are in the midst of a “muddle through” economy – we do not see recession on the horizon but neither do we see the “green shoots” (remember them?) of robust economic growth.
Looking out over the current economic and investment landscapes, here is what we see:
- The global economy remains sluggish but generally positive:
- In the US, the latest estimate for Q1 2016 GDP is a paltry 0.5%, as manufacturing continues to slow, consumer spending grew at a reduced pace, and companies sought to reduce inventories ahead of uncertain demand. The downward trend in both US and global manufacturing is particularly troubling – not only is that reflective of slowing global demand but it also means less good-paying jobs. The Atlanta Fed’s “GDP Nowcast” currently forecasts Q2 growth of 2.5%, a significant increase over Q1 but a forecast that seems to trend lower as each new economic data point is released. On the positive side, employment and wages continue to improve, and wage growth is highest among the lowest paid workers (perhaps a consequence of mandated increases in the minimum wage levels in various parts of the country – that is, artificially (and therefore temporarily) – as opposed to the natural consequences of the laws of supply and demand). The flip side is that most of the job growth is in the comparatively lower paying industries of health care administration, leisure and hospitality, and part-time;
- Europe’s economy continues to slowly improve, especially in Germany, as the effects of the ECB’s “whatever it takes” monetary policies work their way through the system. Greece has re-entered the headlines as it faces near-term refinancing risk of sovereign debt, and its banks’ capital ratios fall perilously low. But the biggest uncertainty is the June referendum in the UK over “Brexit” – the UK leaving the Euro-zone. Recent surveys and polls suggest an overwhelming assumption that the Brits will vote to remain “in the zone”, and our own opinion is that this will be the case. But should the unexpected occur, investors can expect an immediate flight to quality (i.e., US Treasuries) and correspondingly volatile global market conditions;
- A continued strengthening of the yen perpetuates Japanese economic woes. It is unclear how Japan gets out of its economic rut. “Abenomics” was an “all in” attempt to “beggar thy neighbor” by exporting deflation and weakening the yen to improve exports but, at least for now, it simply is not working. The combination of negative interest rates and increasing purchases of government debt by the Bank of Japan is a shell game attempting to delay the inevitable, but it cannot last – as we’ve stated before, Japan has structural and demographic problems that will be difficult to solve with fiscal and monetary policy; and
- China’s growth continues to stabilize as massive fiscal stimulus works its way through the system. The necessary conversion from a manufacturing society to a consumption society continues, but China also faces the demographic headwinds of an aging workforce. Tellingly, there is a massive discrepancy between the official export levels from Hong Kong into mainland China and the (much higher) import receipts back into Hong Kong – in other words, people in mainland China are fabricating purchases from Hong Kong in order to move cash out of the country and into safer havens. We do not anticipate any crisis in China, and its economy continues to chug along, but as always investors should take all official economic reports out of centrally-controlled China with a large grain of salt.
- The US Fed faces both an external conundrum and internal dissension. Official employment rates and inflation figures are at or near target levels. In particular, there seems to be more inflation in the system than is captured by the official CPI rate, as healthcare costs especially continue to rise rapidly. These would seem to signal a green light to the Fed to hike rates in June or perhaps July, and there are at least two publicly vocal Fed members calling for just such a hike. At the same time, Janet Yellen has proven, both in her academic work and in her actions as Fed Chair, to be a devout “dove”, and it is clear that the overall economic health of the US remains fragile, especially manufacturing. While this combination of slow growth and rising inflation does not (yet) merit the infamous 1970s phrase “stagflation”, it does present a conundrum for the Fed, as any rate hike to forestall inflation may further slow the economy, while a lack of action may stimulate further inflation. Our best guess at this point is an outside chance of a rate hike in July, but we still lean toward no action until later this year (September?), and no more than two rate hikes (for a total of 50 bps) in 2016.
- Most global equity markets are slightly positive through April, with continued volatility. At this point it seems clear to us that any further equity rally is dependent on continued loose monetary policy and financial engineering (stock buybacks, increased dividends, corporate restructuring, etc.) – both revenues and earnings growth are down year-over-year. But investors seem weary of the “smoke and mirrors” – an ETF that trades in companies focusing on stock buybacks is dramatically underperforming the broad market S&P 500 index year-to-date. At some point fundamentals have to matter, and this market, to us, seems stretched as we enter the late phases of the economic cycle.
- As an interesting side note, we reviewed recent analysis from our strategic partner Callan Associates and were taken aback by their illustrations that, for the past ten years, there has been no tangible risk/return premium associated with small cap stocks, value stocks, or non-US stocks. Additional analysis from Morgan Stanley suggests there has also been negative performance attribution associated with hedged equity (long/short) strategies. “Drs. Markowitz, Sharpe, French, and Fama, you are needed ‘stat’ in the emergency room…”
- As a group, Dynasty’s active equity managers continue to outperform their collective benchmark (the MSCI ACWI). We continue to believe that increased investor resistance to financial engineering combined with diverging central bank policies bodes well for active management, as fundamental analysis and security selection finally regain traction.
- While global inflation remains muted, commodity prices (especially oil) and other real assets have performed nicely so far this year and, in a welcome change of circumstance, Dynasty’s Real Asset portfolio (including MLPs) is the top performing “super class” in our model portfolios. We over-weighted our MLP allocations in January, and that trade has worked nicely for us so far, though we view it as a tactical move and will reallocate back to policy levels when we deem it appropriate.
- The 10-year US Treasury rate remains below 2% and, more ominously, the overall yield curve is as flat as it has been for years. In other words, the market, through its control of the long end of the yield curve, is signaling distinct pessimism about future economic growth, even as it seems the Fed will look to increase the short end of the curve over the next few months. Our view is that rates will be range-bound for the foreseeable future, with a general drift upward over time.
- In another welcome turn of events, Dynasty’s opportunistic (i.e., credit-oriented) fixed income managers have taken advantage of dislocated credit spreads (especially in high yield) to generate positive returns over the past few months and year-to-date. In the April Dynasty Investment Committee meeting, we extensively reviewed our fixed income “bucket” and we remain comfortable both with our individual managers and our 65/35 split between “core” (i.e., duration) strategies and our “opportunistic” (i.e., credit) strategies.
- Dynasty’s volatility management portfolios – which include both “liquid” and hedge fund alternative investments – are roughly flat for the year, and generally continue to perform as expected in the current market environment. Our May Investment Committee meeting is dedicated to reviewing our Volatility Management allocations and managers, and we will report our conclusions in subsequent Market Commentaries.
In summary, Dynasty’s economic and investment outlook is as follows: The global economy continues to “muddle” along, with positive but sluggish and fragile growth. Advisors should actively manage client expectations with respect to anticipated portfolio performances – we anticipate low to middle single digit returns across most asset classes, with a significant probability of increase market volatility as uncertainty over both economic growth and Federal Reserve monetary policy prevails.
We hate to be boring or predictable, but we continue to favor portfolios that are characterized by global diversification, an intelligent mix of active and passive strategies, and reasonable allocations to both real assets and alternative investment strategies.
Scott Welch, CIMA®
Chief Investment Officer
Dynasty Financial Partners
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