Many investors seem to be starting 2018 with expectations that conditions in 2017 – moderate growth, low inflation – will continue. As a result, they generally remain bullish on equity markets and expect little upward movement in longer term interest rates or widening in credit spreads. This expectation for a continued favorable economic outlook has been bolstered by the recent approval of tax reform in the U.S. It is prudent, however, to be cognizant of the fact that current equity valuations, low long-term rates, and tight credit spreads are also a result of many years of global monetary stimulus. A broader unwind of this stimulus, as has just recently started in the U.S. and the U.K., should, over time, pose a challenge to current valuations (absent an uptick in growth). 2018 will be a year in which the support from monetary policy begins to transition to fiscal policy support. The impact on markets will largely depend on whether this transition drives real economic growth or rather sows the seeds for higher inflation.
Monetary Policy: Removing the Punch Bowl Globally
We are now entering our ninth year of unprecedented monetary stimulus. Proponents have argued that this global effort has stabilized the world’s economies post the global financial crisis. Critics say the policies were unnecessary and have created massive distortions which may pose a risk down the road. Regardless of whether the policy prescription was correct, we must acknowledge that economic growth is now firing on all cylinders in much of the developed and emerging world. This is coupled with low unemployment and tightening labor markets, though the classic economic measures of consumer price inflation still remains muted. We have argued in an earlier PAAMCO Perspectives why we think this may be the case (see The “Internet” of Stocks and Bonds, Q4 2017, www.paamco.com), but believe that there are factors in 2018 (e.g., U.S. tax reform, potential infrastructure spending in the U.S. and a more positive outlook in China) that may lead to higher inflation readings.
Central bankers are in the process of planning their exit strategy. The Bank of England made its first rate hike this past fall. The U.S. Federal Reserve has hiked rates five times and has indicated plans to hike at least three more times in 2018. Furthermore, last October, the Fed began running off its massive balance sheet. The European Central Bank (E.C.B.) is also planning to remove the punch bowl as it is expected to cease its quantitative easing (Q.E.) program in September. So far markets have responded without a hitch as underlying growth remains strong, stocks continue to reach record highs and long-term yields are contained. Given this backdrop, we expect the Fed to continue its stated plan to raise short-term rates in a consistent and orderly manner despite current low inflation readings.
Source: https://fred.stlouisfed.org and http://www.bankofengland.co.uk. As of January 2018.
U.S. Fiscal Policy: Stoking the Inflation Fire?
Much of the economic discussion in 2018 will be focused on the impact recent tax reform will have on both the consumer and corporations. The focal point is likely whether corporations, who receive the largest benefit, choose to make longer-term investments or just use the savings to shore up their balance sheets. It remains to be seen whether this is a long-term positive or just provides a short-term boost. But, more importantly, will the fiscal stimulus result in real economic growth or is it simply a deficit-led hand-out? The answer could determine the ultimate effect on markets.
It would seem that tax reform could get the system’s inflationary juices flowing again after a decade of dormancy. Corporate tax cuts may effectively improve the financial health and competitiveness of U.S. companies. A simpler U.S. tax code for individuals is a good thing and lower rates will help middle class pocketbooks. There is little argument that the U.S. road, rail, bridges, tunnels, ports and airports are in need of modernization. However, if all of this is being paid for by increasing the deficit, will some of the expected economic gains get crowded out by an increase in inflation?
Inflation Risks Lie Ahead
If this is the direction of U.S. fiscal policy with the stock market at all-time highs and unemployment at near all-time lows, what is going to happen to inflation? Though our expectation is that we will see an uptick in inflationary pressure in 2018, we aren’t expecting a large breakout to the upside. Deflationary forces from mobile technology, e-commerce, and even the newly-adopted blockchain may mitigate upward pressure (again, see The “Internet” of Stocks and Bonds, Q4 2017, www.paamco.com). However, a move in inflation from a range of 1.5-2% to 2-2.5% is likely. Such a move will add further support to the Fed’s plan for gradual rate increases through 2018 and into 2019. It will also likely prompt investors to reconsider the term risk premium in interest rate markets that has been absent for the better part of the last decade.
For now, however, markets are still a good way from anticipating higher inflation. After all, investors have been compensated over the last several years by fading an inflation increase. However, if inflation does emerge, it will hurt both business’ bottom lines and consumers’ purchasing power. If coupled with a backdrop of increasing real interest rates, a dreaded double whammy could be created that would pressure corporate profits and disposal income.
In the U.S., the shift from monetary support to fiscal support should result in markets that once again price more according to economic fundamentals than in response to central bank Q.E. programs. Over time, this should lead to a realignment of relative value within and across asset classes. Negative interest rates, negligible term premiums and sub-5% high yield bonds will very likely fade into the history books. Given the current market’s euphoric feel, a reversal could be dramatic as the ability for market makers to absorb risk around a market turn remains questionable. Perhaps more likely, a shift away from the rosy market scenario of today is likely to play out gradually. Signs of economic slack being absorbed are evident in the U.S. as well as in Europe. Wage pressures are starting to emerge in markets with the lowest jobless rates. If these extend more broadly, they will further justify the Fed’s tightening, perhaps even at a faster pace.
The major investment risk in this scenario of higher inflation will first play out in the credit and volatility markets, which we feel are the most distorted by the years of monetary Q.E. If fiscal policies fail to deliver upticks in economic activity that more than offset the upticks in inflation, credit spreads are likely to widen and volatility will likely increase. How quickly this translates into lower stock prices is harder to call, but the move may be large enough that contagion will spread to equities. Clearly central bankers are aware of such a potential outcome and will try to guide policy accordingly to avert a bad outcome, but the fiscal policies put in place at this stage of the economic cycle may take on an inflation life of their own. Until we see consistently higher readings of inflation, the U.S. stock market will probably continue its upward trajectory, particularly as the positive benefits of tax reform on corporate bottom lines translate into higher earnings. Caution is warranted around midyear as the peak of global Q.E. should occur when the E.C.B. is expected to finish its bond buying program around September.
For years, investors have chased yields and rising prices to find places to “park” their money. This has created “bubble-like” conditions in the high yield markets and has flattened yield curves. However, carry on longer-dated fixed income and from credit spreads is at very low levels and it is time to again realize that holding short-term cash or cash substitutes may be more prudent than chasing carry. Low risk alternative strategies, which have the potential to deliver high Sharpe ratio/low volatility outcomes, are a good place to invest while markets are at risk of correcting. Over the next year, these strategies may deliver mid-to-high single digit returns without the asymmetric downside risk of other more traditional investments.
Investors’ liquid alternative portfolios should be positioned in alpha-seeking strategies that generate a moderate absolute return yet can be repositioned quickly if markets reprice and overshoot to the downside. Beta risk, particularly illiquid beta, could be harshly penalized as Q.E.-supported valuations get repriced resulting in both mark-to-market losses and the inability to capture subsequent dislocations. For the first time since 2008, there is a noticeable return on holding short-term fixed income as two year notes are around 2%. If the Fed follows through with its projected rate hikes during 2018, LIBOR rates could end the year around 2.5%. Therefore, an absolute return strategy that seeks L+500 returns could result in portfolio returns of 7.5% or more. Not a bad outcome for a “de-betatized” portfolio.
Overall, the markets are likely to reward active management over passive as the easy money policies of the last several years will likely become something of the past. The recent approval of tax reform and talk of infrastructure spending in the U.S. may mean that inflation will again factor in business risk assessments. As a result, being respectful of downside risk in the equity, credit and rate markets should be an important consideration in one’s portfolio construction.
Basil Williams is a Managing Director and Head of Portfolio Management at PAAMCO. He is responsible for the firm’s completeAlpha approach to hedge fund investing and is the Chief Investment Officer of Horizons, the firm’s fixed-income investment solution. Basil is also a member of the firm’s Investment Oversight and Management Committees. During his career, he has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, he spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980 and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.
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