At the table in the kitchen, there were three bowls of porridge. Goldilocks was hungry. She tasted the porridge from the first bowl.
"This porridge is too hot!" she exclaimed.
So, she tasted the porridge from the second bowl.
"This porridge is too cold," she said.
So, she tasted the last bowl of porridge.
"Ahhh, this porridge is just right," she said happily and she ate it all up.
[From Goldilocks and the Three Bears, by Robert Southey]
Syzygy (noun): The nearly straight-line configuration of three celestial bodies (such as the sun, moon, and earth during a solar or lunar eclipse) in a gravitational system (Meriam-Webster). [Sometimes used to refer to a perfectly aligned state of affairs, or when “everything is clicking.”]
“If something cannot go on forever, it will stop.” (Herbert Stein)
“The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.” (Hyman Minsky in the “The Financial Instability Hypothesis”)
"Trees don't grow to the sky" is a German proverb that is translated from "Bäume wachsen nicht in den Himmel." It suggests that there are natural limits to growth and improvement.” (Source: Simplicable.com)
“Sometimes you just gotta say, ‘What the [heck]!’” (Tom Cruise as Joel Goodson in “Risky Business”)
As we transition from Q3 to Q4, the global economy and markets seem much like that third bowl of porridge in the Goldilocks story – everything is just right. The global economy is humming along, corporate revenues and earnings are solid, wages are (finally) beginning to increase, which should help consumption, oil and commodity prices are generally stable, and inflation, while still disconcertingly low, does not seem to pose a problem.
Nothing is ever completely stable in a world where Donald Trump is president, but the markets seem to be increasingly shrugging off his random tweets, as they also seem to be increasingly sanguine about Central Bank policy. The Fed announced the unwinding over time of its balance sheet and there is now a high probability of another rate increase in December, and yet the market chugs merrily along.
Despite the recent horrific shooting in Las Vegas, three massive hurricanes that inflicted terrible damage, and ongoing saber rattling between the US and North Korea, market volatility remains complacently low – Goldilocks remains safely tucked into the bed that is just right.
We don’t disagree with the market – we remain solidly in the Goldilocks scenario – modest but positive economic growth, low volatility, low interest rates, solid earnings, and low inflation. Barring an exogenous geo-political event, it is hard to see what could knock this cart off its path over the rest of this year.
But since, like the Boy Scouts, we believe in “being prepared”, let’s try. While we hope Goldilocks sticks around for as long as possible, and we think she might at least stay for dinner, let’s imagine three “bear” scenarios that could evolve.
- Baby Bear – Natural Market Correction as Sentiment Changes: Despite the current Goldilocks regime, valuations remain high and multiples are expanding faster than earnings growth. At some point this will stop as people remember that what you earn on an investment is very much dependent on what you pay for it. Our hypothesis for all of 2017 has been that the market was overly optimistic about the passage of the “pro-growth Trump agenda”. It is pretty clear at this point that there will be no healthcare reform, no infrastructure bill (though there will be massive natural disaster relief), and – maybe – a watered down tax reform bill passed sometime in 2018 (but almost certainly not in 2017). If the market begins to “price out” all the economic stimulus it had “priced in” following Trump’s election, we may see a slight-to-moderate market correction. Probability: moderate to high over the next 2-3 quarters.
- Mama Bear – Central Bank Noise: One of the better stories of 2017 has been the increased focus on market fundamentals, earnings, and growth, and the corresponding decreased focus on Central Bank policy, at least in the US. But it is fair to ask: If all of that Fed-driven market liquidity was good for the risk markets, as we were told consistently for years, then shouldn’t we at least wonder how the unwinding of all that liquidity, which is now announced and underway, can also be good for the market, as we are now consistently being told?
Yes, we understand that the unwind will be gradual and telegraphed, and yes, the economy is certainly in better shape than it was back in 2009. But the bottom line is that the Fed is acting on theory – we (nor they) honestly have no idea how or if this will all work out. There certainly is at least the possibility that, this late into the economic cycle and in the utter absence of inflation, the Fed will tighten into an only-moderately growing economy, shutting down the expansion and perhaps even sending us into a recession.
Please do not doubt that we will enter recession at some point – we always have and we always will – the only question is whether the Fed accelerates that start date due to a desire to “normalize” interest rates. Should we enter a recession (or even just visibly slow down), the markets may react strongly. Probability: low to moderate over the next 3-4 quarters.
- Papa Bear – Geopolitics: North Korea remains unstable, as does the consistency of the Trump administration’s foreign policy. As the President prepares to tour Asia this coming November, it is difficult to predict what may happen. Should there be a geopolitical incident with North Korea or China (over trade), the markets may react violently. The recent Catalonian independence vote in Spain (and the government-sponsored violence it engendered), and the relative success of the nationalist “AfD” party in the recent German elections, are stark reminders that the separatist, nationalist, and “anti-Eurozone” movement is not dead in Europe. ISIS continues to claim responsibility for any and all terrorist attacks, and while we don’t know the validity of some of those claims (e.g., Las Vegas), we do know they continue to exist and recruit and radicalize. A major geopolitical upheaval could result in at least short-term market disruptions. Probability: Low over the next 3-4 quarters.
With that as a backdrop, looking out over the current economic and investment landscapes, here is what we see.
The Current Economic & Market Landscape
- The global economy remains solidly positive right now:
- The US revised its Q2 GDP growth rate to 3.1%, the highest since Q1 of 2015. Initial Q3 estimates are 2.7%; GDP growth estimates for all of 2017 remains 2.3% (source: The Wall Street Journal);
- Both the US manufacturing and services sectors remain well in expansionary mode – the ISM manufacturing index hit 60.8 in September (the highest in thirteen years), assisted by a continued weakness in the US dollar (which helps exports). Any reading above 50 represents an expansionary environment;
- Inflation remains a question mark – both the “headline” and “core” (which excludes the volatile food and energy sectors) CPI numbers remain below the Fed target of 2%. While low inflation is generally good for consumers, it creates policy problems for the Fed. The Fed wants to (and almost certainly will) raise rates again in December, and the announced unwinding of the Fed balance sheet certainly represents an implicit tightening of Fed policy. But tightening monetary policy in the absence of inflation is somewhat contradictory, which is why some are concerned about these moves slowing down or stopping the ongoing economic expansion.
- We believe the relative lack of inflation is somewhat explained by three phenomena: (1) slower than expected wage growth – wages are increasing, but not at a pace commensurate with the tightening labor markets; (2) ongoing automation and globalization, which are primary factors in that slow wage growth; and (3) fairly low and stable energy and commodity prices. It is hard to see what might change this dynamic over the medium term;
- It is too early to evaluate Q3 earnings, though estimates for the S&P 500 companies are for a 3.2% increase versus Q3 of last year, on a 5% increase in revenues (Source: Zachs Earnings Report);
- The Eurozone Q2 2017 GDP growth came in at 2.3% (annualized); the consensus estimates for Q3 and Q4 are 2.2% and 2.5%, respectively (source: TradingEconomics);
- GDP and manufacturing are expanding across the Eurozone, with the Markit manufacturing index hitting almost 57 in September (anything above 50 is expansionary);
- Unemployment has fallen to 9.1%, an 8-year low, and annualized inflation through September was 1.5% (both of which are “bad” readings by US standards, but quite positive for the Eurozone). ECB President Draghi continues to suggest a “tapering” of quantitative easing sometime this year, perhaps beginning in October;
- Japan’s Q2 GDP was a positive 2.5% (annualized), and represented the sixth straight quarter of positive GDP growth. The consensus estimates for Q3 and Q4 GDP growth rates are 2.6% and 2.4%, respectively (source: TradingEconomics);
- China’s (official) growth rate for Q2 was again stable at 6.9%, and (official) estimates for Q3 are 7.1%. The PBoC continues to slowly push up rates in an attempt to control massive debt build up and highly speculative real estate prices.
The Dynasty Economic & Market Outlook:
The global economy is growing. Manufacturing in particular is expansionary in most major regions of the world. Oil and commodity prices have risen or stabilized over the 2-3 months in response. Inflation remains lower than expected or desired, though some analysts believe that there are “hidden” inflationary pressures (e.g., wage growth) that have the potential to disrupt the current highly complacent environment. The “Goldilocks” economic regime seems firmly in place, barring a highly unexpected exogenous event.
The three massive hurricanes that hit the US (Harvey in Texas, Irma in Florida, and Maria in Puerto Rico and the US Virgin Islands) caused hundreds of millions of dollars in damage and affected millions of lives, and it will take those areas years to recover, though they will be helped by a likely massive assistance package to be included in the upcoming budget negotiations. The overall economic effects, however, are likely to be fairly transitory.
On the investment side we maintain our general market forecast:
- The global macro-economic environment remains constructive, though still somewhat modest by historical standards;
- Global inflation and global interest rates generally remain low, with little upward pressure on either, despite the Fed’s desire to tighten and “normalize” interest rates;
- The policy and legislative discussions in Washington, DC are likely to amount to “not much” in 2017; there remains some hope for tax reform in 2018, though it will likely be “weaker” than initially anticipated;
- Despite solid earnings, solid revenue growth, and low rates, equities (especially US large cap stocks) still look expensive to us, but it is hard to identify any particular obstacle to at least a modest continuation of the ongoing rally, perhaps for the next 1-2 quarters. Valuations are relatively more attractive in small cap, EAFE, and EM stocks. The US dollar trend is the wild card for US investors (continued weakening will help non-US returns) – we are of the opinion that year-long slide in the US dollar is nearing its bottom;
- The US yield curve remains flat as the market prices in a further increase in short-term rates and low inflation and lower growth in the longer term. We do not anticipate the yield curve to invert;
- At these rates and credit spreads, the public credit markets still look very expensive to us;
- As we anticipated, it is shaping up to be a better year for alternative investments, both hedge funds and liquid alternatives, though we remain more optimistic about hedge funds than liquid alternatives because of fewer liquidity and leverage constraints;
- While we are generally constructive on the global economy and overall market performance, the public markets are not cheap and we still expect mid-to high single digit performance for globally diversified portfolios.
So, as we review the economic and market landscape, we see many good and positive things – a growing economy, solid earnings, low inflation, and low interest rates. We assign a fairly low probability to that regime not continuing through the remainder of this year, but we do see potential issues that we should not ignore.
And we also remember how the story of Goldilocks ends: “Just then, Goldilocks woke up and saw the three bears. She screamed, "Help!" And she jumped up and ran out of the room. Goldilocks ran down the stairs, opened the door, and ran away into the forest. And she never returned to the home of the three bears.”
Scott Welch, CIMA®
Chief Investment Officer
Dynasty Financial Partners
Past performance shown is model performance shown is no guarantee of future results. The model portfolio performance does not reflect actual trading or any advisory, management, or transaction fees, all of which could result in substantially lower results. This does not reflect the impact that material economic and market factors have had on decision making. You cannot invest directly in an index.
Source: Bloomberg, Data Analysis, 1/2017-Present
Source: Zephyr, Data Analysis, 1/2017 – Present
Source: Morningstar, Data Analysis, 1/2017 – Present