by John Goltermann, CFA, CPA, CGMA
April 2, 2018
The US is into its tenth year of recovery from the trough of the great recession in 2008. Throughout this long recovery, the economy has grown slowly, the unemployment rate has steadily improved, and the US stock market has been fabulous!
Since US stocks reached an all-time high a month ago and the economy is hitting on all cylinders, what is next for investors? While we can only hazard a guess, our expectation is that gains will be tougher to come by going forward than they have been over the last ten years and some caution is in order.
One reason to exercise caution is that the long period of the Federal Reserve holding rates at zero is now over and stock valuations are high. While this relates to the market itself, within the stock market there are still many fantastic investment opportunities. Certain sectors such as cyclicals, energy, materials and others have not participated in the rally of the last 10 years. It is interesting to see the stocks that led the bull market now get pummeled and lead stocks lower. This suggests that the future might look very different from the past.
Further reasons to exercise caution here are as follows:
1) The Federal Reserve is unwinding the post-2008 stimulus by selling or allowing to mature $300 billion in bonds by the end of September 2018 and $600 billion by the end of September 2019. Yet the Treasury will also need to borrow $955 billion by the end of 2018 to fund its deficit and this time it won’t have the Federal Reserve to buy up those bonds (at least with its stated goal of reducing its balance sheet). Unless foreign central banks step up, our best guess is that higher interest rates will be required by investors to take up the $1.8 trillion of new supply in the next 18 months. Many asset prices depend on low rates continuing.
2) The recent fiscal stimulus (high spending levels with new tax cuts) in an already strong economy that has full employment could easily bring inflation. Indicators such as rising producer prices, wages and a weakening dollar now warn of a coming increase in consumer price inflation.
3) Trump Administration rhetoric around new tariffs have investors on edge. While we don’t believe an all-out trade war is in the cards, the belligerent tone and the potential for trade friction will continue, keeping investors sensitive to trade pronouncements.
To give a quick analysis on the tariff threat, the reason why it is probably not as big a deal as the media makes it, is that Trump is playing to his base, which is in favor of protectionism. Ohio, Michigan and Pennsylvania were the swing states that got him elected and he is trying to keep his promise to them. But Trump is also highly sensitive to what the stock market does and equities would suffer mightily if a trade war broke out. Protectionism might make sense if there were masses of unemployed workers, but that is simply not that case today.
Furthermore, most trade these days is in intermediate goods, so it doesn’t make sense for Mexico or China to put tariffs on goods that are assembled into final goods and re-exported to the US and the rest of the world (which creates jobs for their citizens in the process). The fact that the United States imports much more than it exports gives Trump leverage. Simply put, the US stands to lose less from a trade war than most other countries.
Nevertheless, worries about a plunging stock market will constrain Trump from acting too aggressively. Trump already appears to have agreed to excluded Canada and Mexico from the countries subject to tariffs.
Because of an overheating economy and increasingly restrictive monetary policy, investments that have worked very well in the past will likely no longer work as well, and what didn’t work in the past may start to work. We wrote about this in a recent piece -- as energy drops to 5% of the S&P (a historic low level) and technology moves over to over 25% (historically high), it is prudent to shift more towards underweighting technology and overweighting energy.
This is what we are doing as we move into a different investment backdrop:
1) Exercise patience with positions that we would like to buy in the long run as valuations remain high. Volatility brings more frequent opportunities;
2) Invest in more in global equities which have been out of favor during the US rally and benefit from a weaker dollar environment;
3) Add some inflation protection with gold mining and energy stocks in the equity mix as many have been extremely out of favor since 2011, to levels where there is not much downside risk. The mining companies have gone through a long period of retrenchment;
4) Keep the allocation to stocks on the low end of ranges while maintaining enough equity investment to meet long term objectives. While we are not market timers, tactical trades with changing conditions can help reduce risk and earn gains in overlooked areas ripe for turnaround;
5) Keep a value tilt (as opposed to growth) in equity portfolios. The relative performance between value and growth stocks tends to move with the dollar index. As the dollar strengthens, growth stocks outperform, and as the dollar weakens value stocks do better. The blue line on the chart below shows the relative performance of growth vs. value stocks, in other words as it rises growth stocks outperform, and as it declines value stocks outperform. This is likely to be because while the dollar is strong and inflation correspondingly low, investors are willing to bid up the shares (and multiples expand) of companies that promise more growth in the future, as those future earnings will not be in the form of less valuable dollars;
6) Continue to invest in select stocks that pay dividends (which signals a higher earnings quality) but that are also not interest rate sensitive;
7) We will avoid the big winners of the last ten years (Facebook, Amazon, Netflix, etc.), avoid companies that are highly leveraged and vulnerable to increasing credit costs, and some of the more overvalued defensive positions; and
8) Keep bond durations short to protect from principal loss as the pressure on interest rates is to the upside.