Well, the transition from the “Plough Horse Economy” to the “Goldilocks Phase”, which we referenced in our January newsletter, appears to have shifted quickly to “Late Cycle Stimulus” concerns. This shift, prompted by the passage of the February Congressional Budget (in which spending caps were raised by $300 billion) on the heels of the 2017 tax reform, highlights the normal inflationary expectations that emerge as demand rises when labor and capital goods constraints are loosened.
The markets, in anticipation of Fed tightening to offset expected inflationary pressure, reacted quickly in February with investors dumping both equities and bonds. This triggered the re-emergence of equity volatility as the VIX (measure of equity volatility) spiked and the overall level of volatility has remained higher.
Where does this leave us? It seems that the recent price action in equities confirms that we are pretty deep into the later stages of economic growth, which has entered its 10th year. Investors now must assess higher valuation metrics (i.e. Price/Earnings or P/E ratios) against expected and reported earnings (i.e. EPS or earnings per share) in the context of increasing interest rates. In the later stages of economic expansion, valuation levels (i.e. P/E ratios) are likely to head lower first. This is usually followed by a delay in declining earnings growth but accompanied by rising interest rates.
Stimulation at this stage of the economic cycle can be worrisome if it spurs demand for goods and services and is not accompanied by further private sector investment in capacity to meet the demand. Therefore, with tight labor conditions, as measured by unemployment, and many companies applying their tax savings to stock buy-backs and mergers as opposed to capital expenditures, both the markets and the Fed are naturally inclined to raise interest rates in order to offset expected inflationary pressure.
A further contributing factor to shortening of the economic expansion is the crowding out of capital for investment by the U.S. government as it expands its budget, which could bring both higher deficits and levels of debt issuance. This occurrence would simply apply further pressure on rising rates and weakening demand and hence recessionary pressures.
This economic story line is taking place against a backdrop of trade war posturing and upcoming Congressional elections in the fall. Therefore, it is a bit challenging at the moment to project a strong rally in equity or bond markets as we enter the second quarter of the year; though a year-end equity rally post-election, supported by trade policy stability, is certainly a possibility. Both actual inflation and real interest rates remain low, notwithstanding the gradual tightening that is being orchestrated by the Federal Reserve and other Central Banks globally.
As noted in prior newsletters, one should not underestimate the challenge that faces our new Fed Chairman, Jerome Powell. The metaphor of a golf swing comes to mind when one thinks about the timing and pace of Fed tightening with rates still low and economic stimulus so strong ten years into an expansion. If Powell and the other major Central Banks tighten too quickly, then an early recession leaves a rather thin margin of error for dampening any severity of correction.
At Cassia our approach to investing relies on a disciplined, repeatable process that avoids market timing and depends upon diversification and a recurring assessment of expected risk. This assessment of expected risk is based upon observable volatility and correlations across economic sectors, global markets, and asset classes. We believe that to reach individual financial goals the question is not whether to be invested in liquid financial markets (depending on market trends) but at what level of expected risk given an assessment of macro economic factors. Measuring risk and diversification are our primary navigational tools.
Our outlook for the current quarter is for equity markets to remain on a bumpy path without any expectation for sizeable gains. Economic factors remain positive and investable cash is still significant. This will support markets as the current level of volatility, being sparked by late cycle stimulus concerns and valuations, generates periodic downdrafts. Unfortunately the correlation between bonds and interest sensitive equity sectors (i.e. real estate, utilities, energy, and consumer staples) is rising which puts added pressure on lower volatility strategies in the short run.
As we move through the current quarter, we expect to further reduce the duration in our fixed income allocations, raise our overall exposure to inflation-linked treasuries, and maintain our core allocations to gold and equity volatility. However, our strategies will maintain a healthy allocation to both U.S. and international equities as we focus on long-term investment success.