With the Federal Reserve's 2018 Jackson Hole Economic Symposium now over, markets continuing to hit new highs, and the economy seemingly humming on all cylinders (lots of people are employed, corporate profits are strong, and the Q2 gross national product was just north of 4%), we thought it would be a good time to check in with some of our macro-minded experts on Marketplace to get their take on interest rates, inflation, and where the economy might be headed next (just how close are we to a recession, anyway?). The authors we spoke to agree that rates will continue to rise gradually and steadily in the near term; that inflation risk, while small at this point, would be problematic for investors; and that, as common sense would dictate, the timing and severity of recessions is tough to pin down. They also propose some timely investing ideas to consider in the current environment, including high-yield instruments and a contrarian play on Chinese stocks. To find out more about how our authors are thinking about the current state of the economy and what investors should be watching for, keep reading.
Topdown Charts, author of Weekly Best Idea
(Editor's Note: The following questions and answers were submitted between August 30 and September 5, 2018, so some of the information herein may not reflect more recent news updates and market fluctuations.)
Seeking Alpha: Federal Reserve Chairman Jerome Powell said at Jackson Hole that he expects rate hikes to continue. Do you foresee the two planned additional hikes coming this year? When do you think the Fed will stop raising interest rates?
Lance Roberts/720 Global: The Fed under Jerome Powell has been very clear that they intend to keep raising rates at a gradual but steady pace. Real rates remain very low and stimulative relative to the extent of the economic recovery. That should fuel rising levels of inflation, especially given the recent rounds of fiscal stimulus at a time of full employment. The current circumstance offers further incentive for the Fed to maintain the path of rate hikes. Powell likely wants to build room to employ traditional monetary policy stimulus while the economy is giving him the latitude to do so. Ultimately, the stock market is the Fed’s barometer on terminal Fed Funds and will tell Powell when enough is enough.
Rida Morwa: It is clear that the U.S. Fed will remain cautious through gradual and less aggressive rate increases in the future. We believe we are set to see one rate hike in 2018, or possibly two, but also a sharp deceleration of rate hikes in 2019 and beyond. We probably will never see in our lifetime rates go back up to 5% or above. Our views are that we are approaching the end of the interest rate increase cycle and that the risks of investing in Mortgage REITs (or in most high-dividend stocks or bonds) is lower today than it was in the past two years.
Note that Federal Reserve Chairman Jerome Powell has hinted that the end of policy tightening is nearing and that he sees no signs of a sharp rise in inflation above the Fed’s 2% target or an elevated risk of the economy overheating. Because inflation has responded only weakly to declining labor slack, inflation “may no longer be the first or best indicator of a tight labor market and rising pressures on resource utilization,” he said. “Thus, risk management suggests looking beyond inflation for signs of excesses.” This is a clear sign that the U.S. Fed is well aware that the global economy is still fragile and that further aggressive rate hikes may not be needed, even if inflation exceeds the Fed's target rate.
Topdown Charts: Yes. The data remains consistent with a tight labor market and gradually accelerating inflation. There is still material upside risk to inflation, and the Fed doesn't want to get caught too far behind the curve lest it has to hike more aggressively - which would be the kind of scenario that might precipitate a more rapid deceleration in growth. I think their focus is on trying to reduce economic volatility and not accentuate it like they arguably did in the past cycle. I don't have a specific time frame for a pause in hikes - the key variables I am watching on that front are: emerging markets macro, the impact of QT, and just the out turn of the inflation and capacity utilization data.
SA: Why are market expectations different from the Fed’s expectations, according to the Fed’s most recent dot plot?
LR/720: We recently wrote extensively about this divergence in an article we penned for our Marketplace community: "Everyone Hears The Fed... But Few Listen." One of the key takeaways from the article was as follows: “Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.” In short, since the financial crisis, the market has become accustomed to a Fed that has failed to deliver on rate hike promises. That seems to have changed with plain-speaking Chairman Powell.
TC: The market has consistently underpriced vs. the Fed expectations, so I wouldn't say this is something new per se. I guess though one explanation is that arguably the market is both more pessimistic than the Fed on the economic outlook, and more complacent on the risk of higher inflation. If this interpretation is true, then it creates an interesting investing backdrop, because if growth continues and inflation accelerates, it will mean many market participants will be caught wrong-footed.
SA: What’s the deal with inflation? Is the Fed being too complacent about inflation risk and their ability to “control it” at all costs? What are the odds of inflation upside?
LR/720: Yes! Yes! And who knows. First, it is important to clarify that rising prices are a symptom of inflation caused by too much money in the economic system. Given the actions of central bankers over the past 10 years, there is no question that condition exists on a global scale as never before. The manifestation has been different in this cycle than in the past and is showing itself in asset prices as opposed to the costs of goods and services. The biggest risk, albeit small at this point, is the combination of inflation and recession (stagflation). In this event, the Fed would be forced to reduce liquidity and raise rates. This is a scenario that has not been witnessed in decades and would be a difficult combination for most stock/bond investors.
RM: Inflation got a big boost during the year 2018 due to the tax cuts, including the tax gifts that were given to corporations to repatriate money back to the United States. It is our views that the rate of inflation will slow down in 2019 and beyond as the effect of these tax cuts phases out.
TC: You can't rule out upside risk to inflation when the labor market is this tight (and not just in America, but also globally; we are seeing tight capacity across developed economies). In fairness though, a drastically stronger US dollar would bring deflation risk into play. But I would say the Fed is being appropriately cognizant of inflation risk, and they certainly have the tools to combat inflation... even if those tools are blunt and bring with them side-effects.
SA: There's a chart we saw recently that shows the S&P 500 steadily climbing to dizzying heights over the past decade. At what point do you think the Fed tightening will derail the S&P 500 and the bull market?
LR/720: Market valuations are clearly at historical peaks. It is being driven largely by behavioral tendencies and importantly central bank liquidity. As the Fed further reduces liquidity and the ECB and BOJ begin to take similar steps, the odds increase that equity markets falter. We are already seeing the effects of reduced liquidity in Turkey and other emerging market nations. That said, picking a date is a fool's game as this market seems to be very good at ignoring reality.
RM: Again, our views are that the Federal Reserve does not have much room to hike interest rates by much, and that the pace of rate increases will slow down significantly starting mid-2019. This will help the current bull market continue. In fact, we are very bullish on equities in general, and on high-yield stocks and sectors in particular. Most high-yield stocks and sectors have not participated in the bull run that started in November 2016, and many are currently trading at their lowest valuations in years. We believe that allocating funds to these high-yield sectors is not only a defensive move, but a move that is set to be a very profitable one.
Demand for high-yield is set to continue, and we believe that the current generous yields offered by many of these sectors such as Business Development Companies (BDCs), Property REITs, Renewable Energy companies, and traditional Midstream MLPs are set to compress over the coming few years. This is a unique opportunity for income investors to start positioning themselves in these sectors.
TC: A specific metric I watch is the level of the Fed funds rate vs. wage growth - I call this the sweet spot indicator. Basically, the higher wage growth is relative to the level of the Fed funds rate, the better it is for stocks (greater confidence, income, borrowing power), and the higher the Fed funds rate is relative to wage growth the worse it is for stocks (tighter credit, heightened risk of recession). At this point, I would say we're still in the sweet spot.
SA: Recession: are we there yet? How close (or far) are we from an economic slump?
LR/720: We have had some close calls since 2010, especially in late 2015 and early 2016, but central bank intervention has delayed the rhythm of these cycles. In the same way, however, that suppressing forest fires eventually result in even more uncontrollable outbreaks, this seems to be a similar likelihood for the global economy. Debt (and leverage) is the lowest common denominator as a determinant for a recession and, again, the level of interest rates will eventually be the trigger. Rate hikes naturally are bringing us closer to that point, but the trigger is unknowable. Watch real rates, the yield curve, and credit spreads.
RM: An investor cannot take a view on the U.S. equity markets without taking a view on the state of the U.S. economy because most equities would suffer in case we hit a severe recession. Currently, the probability of a recession appears to be pretty low if we look at economic data released from the United States and the activity from the Federal Reserve. At the most recent Federal Reserve meeting, the Fed confirmed their confidence in the U.S. economy through an improving job market, rising economic activity, and consumer spending. They also indicated that future increases would be gradual and dependent on continuing promising results from the indicators discussed above. One does not have to rely on the views of the Federal Reserve; the numbers speak for themselves.
TC: Recessions are notoriously hard to pick - my peers who like to forecast could be said to have predicted 12 of the last 3 recessions. That said my lead indicators say the risk of recession in the next 1-3 years is higher than usual, but the higher frequency hard data and confidence indicators show growth is still solid - no imminent collapse is observable at this point. We're definitely late cycle, but not end cycle yet.
SA: The US dollar is key for many asset classes and critical for potential emerging market issues. What’s your outlook for the US dollar both near and long term?
LR/720: Given the global demand dynamics and the pressures being imposed by a Fed that maintains a path of rate hikes, the dollar should sustain it recent strength and continue to move higher in the short to intermediate term. Long term, the dollar outlook is problematic due to the amount of U.S. debt outstanding, the extent of money printing that will likely have to occur in order to avert a default and the converging global efforts by major economies (especially China) to reduce their reliance on dollar-based transactions.
RM: Emerging markets have taken a hit not only due to a rising U.S. dollar, but mostly due to the recent trade sanctions and related escalations. We believe that emerging market equities have overreacted and that they present a unique buying opportunity. There’s reason to believe that the trade war should be ending sooner than later. On August 27th, the U.S. and Mexico reached an agreement to overhaul the North American Free Trade Agreement (‘NAFTA’). The new deal would rewrite parts of NAFTA, in a three-country trade deal that includes Canada. We expect that Canada will also sign the agreement, and this will remove a lot of economic and political uncertainties that the recent trade war escalations have brought. This news is significant because it is a good indication that President Trump trade war escalations have been more of a negotiating tool rather than a protectionist behavior that many have accused him of. In fact, this strategy has proven to be successful so far. This also opens the door for the possibility that a trade deal could be struck with China soon, which will also be bullish for global and Chinese equities.
Furthermore, President Trump is set to meet his Chinese counterpart President Xi Jinping in a G-20 summit in Argentina, which begins on November 30. This raises hopes that the two countries might find a solution to end the dispute. We should note that the two have not met since late 2017. There is a good chance that some sort of agreement, or de-escalation of tensions could occur, and this could result in higher equity prices for emerging markets.
While we have no crystal ball, we can conclude from the trade war thus far that no one seems to be really benefiting as any new tariffs imposed from the U.S. are just met with an equal amount of tariffs from China. We believe that the political drama will eventually end, perhaps soon, and that Wall Street will then give appreciation to the emerging markets and, particularly, the Chinese economy, which is clearly firing on all cylinders.
In fact, we have very recently started to recommend to our investors to initiate a position in equity Closed-End Funds with an exposure to China.
TC: I anticipate further upside risk for the US dollar in the medium term as valuation overshoot is the typical pattern, fueled I think in this case by still substantial yield support, quantitative tightening, macroeconomic divergence, and shorter term, the prospects of Chinese devaluation and EM stress raises the specter of a feedback loop, which could drive the US dollar higher. Longer term, these things tend to move through long-term cycles, and we've already been through a decent bull market in the US dollar, but I wouldn't start to get structurally bearish on the US dollar until the monetary policy, yield differentials, and valuation picture really laid out a high conviction case.
SA: What would you say to investors who are looking to protect themselves against potential market and inflation risks?
LR/720: We own house and car insurance for events that are highly unlikely. Why shouldn’t we consider owning financial insurance, especially when the risks of a significant drawdown are substantial? As Falstaff said in Shakespeare’s King Henry the Fourth, “Caution is preferable to rash bravery.”
TC: At this point in the cycle, the reality is you have to shorten up time horizons and heighten focus on risk management. It's not the time to go all cash unless you're okay with potentially missing say a potentially large upside overshoot in risk assets. But as we get later in the cycle, the odds of a deeper correction or bear market naturally rise - it's just the nature of the business cycle and markets. Rather than suggest certain hedging strategies, I would say focus on asset allocation. There's a lot to be said about intelligent diversification, being active in your approach, and have a solid process which relies on good indicators.
SA: What’s one investing idea, macro or otherwise, that you’re especially excited about at present? What’s the story?
RM: As discussed above, we are excited about many opportunities still offered in the high-yield space.
We are long-term investors, and value stocks tend to outperform growth stocks in the long run. We can see the long-term performance of Value Stocks versus Growth stocks in the chart below:
Since this leg of the bull market started in November 2016, growth stocks have been on a non-stop rally, and currently trade at highly excessive valuations. We should note that the leadership in the U.S. equity markets during the year 2018 has been confined to a narrow group of tech stocks. In fact, Amazon (AMZN), Netflix (NFLX), and Microsoft (MSFT) account for 71% of the S&P 500 index total returns so far this year. Apple (AAPL), Facebook (FB) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) account for another 27%.
That means these 6 stocks, by themselves, have contributed 98% of the market's returns this year. If we back these 6 stocks out of the S&P 500 index, the index would actually be almost flat for the year. This is because while the S&P 500 index might hold 500 different stocks, 450 of those have little to no influence on returns. While the major averages might be near record highs, but it's not quite so rosy for all the stocks. About 50% of all stocks trading on U.S. exchanges have posted returns of 0% or are in negative territory for the year 2018, with many stocks being substantially in negative territory. This comes at a time when the tech heavyweight are trading at very lofty valuations and carry substantial risk. This is the reason why many managed funds (including mutual funds) have under-performed the S&P 500 index during the year 2018. I would not count on these high-growth stocks to keep delivering 50%+ annual returns in the future. Sooner rather than later, value stocks (including value dividend stocks) will come back roaring.
Another good reason to invest in "value stocks" is that they tend to be less risky, and less prone to investor speculation and related euphoria. Having lived through the dot.com bubble crash of the year 2000, I am very skeptical when it comes to investing in stocks that come with a Price/Earnings ratio of 20 times or above. I just do not like this kind of risk, and this is where our value approach has originated. At the time of the dot.com bubble crash, many of the high-flying tech stocks lost 90% of their value and more.
There is a very strong case to be made for allocating to value-oriented stocks in 2018 and beyond, especially at a time when growth stocks are trading at extreme premiums to value stocks, and the dispersion in market multiples is well above the long-term average. The performance of value stocks has tended to be disconnected from economic and market cycles and therefore they tend to be much better investments in the long term.
While many market pundit keep posting that equities are expensive, this is just not the case for most "value stocks", including the high-dividend "value stocks" that we invest in. Such sectors include Property REITs, BDCs, Midstream MLPs, Renewable Energy Stocks, some Utilities stocks, and other high-yield stocks that have been out of favor since the beginning of this rally in November 2016.
With a view that we are nearing the end of the interest rate hike cycle, we believe that many of those sectors that have been neglected by investors are set to see renewed interest and a strong run. Our view is that too many interest rate hikes have been factored into many of the high-yield sectors, even into those that tend to perform well during periods of rising interest rates. We believe that the “High Dividend Opportunities” portfolio, which is focused on high-yield “value stocks” is set for a strong out-performance over the next 2 to 3 years at least.
TC: There's a couple of interesting contrarian plays which are starting to look attractive. One of these is Chinese stocks (I talked about this with members on Weekly Best Idea). The valuation picture has vastly improved and the slew of headline risk and usual permabear narrative on China has created an opportunity there. The key catalyst will be either on the upside that growth just plods along and swamps the negative sentiment, or on the other side that the authorities get spooked and decide to undertake a more forceful and coordinated stimulus program. It goes to show in this environment of heightened political risk that risk and return are two sides of the same coin.
What do you think - is a recession coming soon? When do you predict the markets will reverse their heady climb? Are you shifting your investment strategy at all to deal with a near-term market downturn? Share your thoughts in the comments below.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.