2018 4Q Economic Capital Market Outlook

If you have been invested in the U.S. equity markets over the past five years, you have experienced a solid return and resurgence in the market value of your investment portfolio. In its basic form, a capital market, is simply a mechanism for pricing risk. Over the past five years, we have seen increases in prices on publicly traded risk assets, such as stocks and high yield bonds. However, markets are not necessarily efficient at pricing risk all of the time. Equity investors have been richly rewarded over the past five years in spite of growing global risks. However, this period of rising equity prices and low levels of volatility is about to be tested as the global economy transitions and capital markets adjust to higher interest rates. The risk premium, which investor’s demand on risk assets, needs to adjust higher.

The U.S. economy is performing extremely well and remains one of the stronger pillars in the global economy. The unemployment rate is near record lows, wage inflation is taking root, and consumer confidence is high. In addition, excess resources that have persisted in the economy for many years are being put to use as capacity utilization improves and occupancy rates in real estate increase. We are even starting to see improvements in productivity gains that have been illusive throughout this period of economic growth.

After working through the Financial Crisis and slow economic growth that followed, we believe an inflection point is near. The Financial Crisis required massive Federal Reserve intervention, such as regulatory bank reform and quantitative easing, resulting in distorted economic and capital market activity. We are now experiencing an economic period unlike any other in history. This is evidenced by a zero percent real Fed Funds Rate and $4.2 trillion in debt on the Fed’s balance sheet, which it had purchased in the open market. As a result, comparisons to past recoveries provide little guidance. So, within our investment matrix, we continue to cling to those things we are clear on:

  1. When money supply grows, prices of financial assets rise.
  2. When central banks reduce interest rates to low levels and keep them there for a long time, asset prices increase.
  3. When monetary policy shifts tighter, volatility increases and markets inevitably dislocate.
  4. The credit cycle still exists.

It is important to separate the corresponding impact of the cumulative regulatory, political and central bank decisions on the economy from its impact on the capital markets.