Everything’s Gonna Be Alright (?)

The Current Economic Landscape

The global economy continues to grow, though with distinct signs of slowing down outside of the US:

• The consensus estimate for Q3 GDP growth in the US is now a solid 3.2%. That growth is then expected to decelerate slightly to 2.9% in Q4, bringing overall 2018 GDP expectations to 3.1%; (source: The Wall Street Journal);
• This GDP forecast remains sensitive to ongoing trade negotiations, and the situation with China appears to be deteriorating, as both sides recently announced additional tariffs. President Trump seems determined to mitigate both the trade deficit with China and the theft of intellectual property and, once past the mid-term elections, the consensus belief is that he will lean fully into a trade war. We hope not, as it seems to be one of the few scenarios that could derail (or at least slow down) the US economy over the short-term;
• Both the US manufacturing and services sectors expanded in August, with the PMI (manufacturing index) coming in at a stunning 61.3, versus 58.1 in July, and the NMI (non-manufacturing index) coming in at 58.5, versus 55.7 in July; any reading above 50 is considered expansionary. The manufacturing index has now been in expansionary territory for 112 consecutive months, while the non-manufacturing index notched its 103rd consecutive expansionary month (source: Institute for Supply Management);
• Inflation (as measured by CPI) rose 2.7% year-over-year in August, down slightly from 2.9% in July. Oil prices fell through most of August, though they rose steadily in late August and again through September, and are now up more than 17% on the year. Wages finally are starting to increase, but a slowing global economy outside the US, especially in China, is keeping commodity prices under control (even falling). The Personal Consumption Expenditure (PCE) index – which is the Fed’s preferred measure of overall inflation, increased 2.3% year-over-year in July (the most recent reading), generally in line with the Fed target rate (source: TradingEconomics).
• We continue to believe that inflation will increase slowly over the rest of this year, but will remain somewhat dampened by (1) continued slow (but positive) wage growth; (2) a generally strong dollar; and (3) a decelerating global economy (ex-US), which will dampen demand. As such, we continue to believe that inflation does not yet constitute a primary risk to economic growth;
• As expected, the Fed raised interest rates in late September. They have signaled that any rate increase in December will be “data-dependent”, but we expect them to raise rates again, despite vocal protests from President Trump, who has made it clear that he wants the dollar weaker and interest rates kept low (he is unlikely to achieve either objective);
• The yield curve remains very flat as the Fed raises rates on the short end but the long end remains “tamped down” by high demand and a lack of inflation fears. As of this writing, there is less than 30 basis points difference between the yield on the 2-year and 10-year Treasury.
• The 10-year rate has risen above the psychological barrier of 3%, and we repeat that we do not anticipate (or fear) an inverted yield curve – should one occur, we believe it will be because of investment flows and Fed actions, not a harbinger of an imminent recession;
• The US dollar generally remains strong. It was largely stable through August, but began weakening against the euro as we moved through September, while remaining strong against the Japanese yen and Chinese yuan;
• The Q2 earnings season is now over, and we saw the strongest quarter since 2010. S&P 500 companies posted a 25.4% increase in earnings on 9.8% higher revenues. Overall Q3 S&P 500 earnings are expected to increase 17.6% on 7.3% higher revenues. Earnings expectations for all of 2018 are expected to be +20.7% on a 6.7% increase in revenue. Growth is still expected to decelerate as we head into 2019, with earnings growing of 9.7% and revenue of 5.1% (source: Zachs Earnings Report);
• Manufacturing across the Eurozone remains expansionary, with the Markit Manufacturing index falling slightly to 53.3 in September, versus 54.6 in August. Contrarily, the Services index rose slightly from 54.4 in August to 54.7 in September (source: TradingEconomics);
• Eurozone unemployment remained at 8.2% in July, unchanged from the June reading, and it remains at its lowest level since December of 2008. Annualized inflation went up 2.0% in August, down slightly from July (source: TradingEconomics);
• Japan’s GDP rose 1.9% (annualized) in Q2, after a decline in Q1 GDP. The expansion was driven by strong consumer and business spending. The consensus estimate for 2018 GDP growth is 1.7% (source: TradingEconomics);
• China’s (official) GDP growth in Q2 was 6.7% (annualized), and it is expected to post an (official) growth rate of 6.6% for all of 2018. There are other (non-official) signs, however, that the Chinese economy is slowing faster than the official numbers indicate. For example, the Chinese Caixin Manufacturing Index fell to a 14-month low of 50.6 in August (source: TradingEconomics).

The Dynasty Economic & Market Outlook:

• The global economy continues to expand, though there remains a distinct “desynchronization” of growth. The US economy shows continued growth as the full effects of fiscal stimulus and regulatory and tax reform work their way through the system. At the same time, the rest of the world appears to be decelerating – still expansionary, but slowing down (especially in China);
• US Inflation is trending higher, but we maintain our belief that it (as of yet) does not represent a problem for continued economic expansion. Wages in the US are increasing only slowly, oil prices are rising again but do not yet seem problematic, and overall commodity prices remain repressed by slowing demand and the generally strong dollar. Outside the US, inflation simply is not a problem, despite the rise in oil prices;
• In the US, tax and regulatory reform and fiscal stimulus are winning the economic tug-of-war against monetary tightening, and continue to pull future consumption forward as consumers and small business owners lean fully into the ongoing recovery. At some point, the markets will need to be concerned again about massively increasing deficits and debt, but right now these issues are taking a back seat to economic expansion, a bullish market, and ongoing partisan nastiness in Washington, DC;
• Solid US GDP growth, as well as solid earnings and revenue growth, make for a generally positive market environment, and we maintain our view that stocks will end the year higher than where they began. However, decelerating earnings growth, decelerating economic growth, and generally rising interest rates will most likely combine to push valuations down and volatility up, especially as we head into what looks to be a bitter mid-term election cycle;
• Ongoing trade tensions remain by far the largest threat to the current “Goldilocks” economic regime;
• EM and EAFE (Developed International) markets continue to be hurt by a generally strong US dollar, trade tensions, and a corresponding “risk off” mentality driving investment outflows. We still like EM and EAFE as longer-term positions, from both a valuation and economic growth perspective, but investors should expect continued volatility and probably negative performances for the year (in US terms);
• At current interest rates and credit spreads, the public credit markets continue to look very expensive to us, and our return expectations are muted accordingly. We are nearing the end of the current credit cycle and risks are increasing;
• Many investors increasingly are turning to shorter-duration bond strategies and even cash solutions, which finally have a positive real yield again due to the Fed rate hikes. The curve is so flat that investors simply are not being sufficiently compensated to take on term or duration risk;
• For investors who can access the private markets and handle some degree of illiquidity, we still believe there are better opportunities in the private markets versus the public markets, though investors face compressed premiums versus historical levels, driven by huge investment flows over the past 18-24 months, and performance will be very manager and strategy specific;
• We expected that rising rates, increased volatility, and greater security price dispersion would create a more positive environment for both traditional active managers and for alternative investments. This generally has been true for most of the long-only and hedge fund managers we recommend, though we remain somewhat disappointed with the overall performance of the liquid alternatives space (i.e., ’40 Act mutual funds that trade in non-traditional strategies);
• With most public markets viewed as at least fully valued, many investors are revisiting the use of alternative investments within their portfolios, both for diversification purposes and as a means of accessing lower-correlated sources of potential return. We continue to believe that hedge funds generally will deliver superior performance than their liquid alternative brethren, because of less liquidity and leverage constraints;
• We have muted our expectations for real assets and the overall commodity complex, due to lower than expected global inflation, slowing demand, and the strong US dollar;
• While we generally are constructive on the global economy and overall market performance, the public markets are not cheap. We see little reason (barring exogenous geopolitical events) why the market cannot move higher over the rest of the year, with increased volatility. We also believe, however, that clients need to have their expectations managed as to what a globally diversified portfolio can deliver over a full market cycle.

The US economy is performing well, as the full effects of tax reform and fiscal stimulus flow through the system. Other than ongoing trade tensions, a brutal Supreme Court confirmation process, and isolated geopolitical drama, the global economy is chugging along. We expect things to slow down sometime next year, perhaps sooner if the Fed continues to increase rates and the Democrats regain control of one or both houses of Congress following the mid-term elections (a scenario that seems to be increasingly probable).

As the expression goes, let’s make hay while the sun shines, but let’s not get too “grasshopper-like” forget our “inner ant”.

© Dynasty Financial Partners

www.dynastyfp.com

© Dynasty Financial Partners

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