As an economic cycle ages, inflation rises as demand outpaces supply. As a result, the central bank increases interest rates, thus lowering demand relative to supply. At an inflection point, demand is lowered by enough relative to supply that monetary velocity slows, excess capacity exists, and a contraction begins. In advance of the onset of a contraction, the central bank has lifted short-term interest rates above long-term yields (which represent the market’s price of money given projected inflation rates), thus inverting the yield curve. Since this has not happened yet, we believe there remains time in this secular bull market; however, just as importantly, investors should now expect periods of selloff and consolidation.
This is not unheard of historically, with two notable examples in 1984 and 1994, as noted earlier. In both years, we saw market corrections when the Federal Reserve had not yet gone past the point of no return. Given the relatively uniform move higher in U.S. equity markets since 2009, investors may not be prepared to deal with the ramifications and are likely to view volatility as a sign of the beginning of a bear market resembling the last two bear markets. History, however, is chock full of examples of sharp equity market declines without recession. Again, while these can be painful in the short-term, they are healthy for the market longer-term.
Since the bottom in March 2009, only Thai stocks have outperformed U.S. equities, and it is unlikely there were many investors shrewd or bold enough to allocate a majority of their portfolio to Southeast Asian securities. Our takeaways are as follows:
The gap between the economy and equities has been larger than in previous cycles, and
Diversification of any kind outside of U.S. equities has led to underperformance.
The latter’s impact on the hedge fund community over the past 10 years is illustrated in Figure 6. Quite simply, diversification has failed on the back of overzealous central bank policy which disproportionately affected U.S. equities at the expense of other asset classes. This has led not only to a gross underperformance in the hedge fund community, but among active managers in general. As can be seen in Figure 7, if we look at the percentage of active managers outperforming their benchmarks, it is surely no coincidence there is a large drop-off concurrent with central bank policy following the global financial crisis.
The move off a zero lower-bound interest rate is poised to effect changes in the capital markets, which is healthy in the long-run, thus creating opportunities. However, the flip side to the rate increase may be a painful adjustment period in the short term; we believe this may have been a large factor in the December selloff. The consumer remains strong and although the economy is showing signs of slowing, there appears to be a second-derivative effect, which, in our opinion, does not justify a ~10% decline in one month. Higher interest rates should continue to bring greater dispersion into the markets, thereby separating winners from losers rather than effecting a “no losers” market in which active managers are destined to underperform.
As seen in Figure 6, 2018 was the first year since 2008 in which active management showed signs of adding value; given the move in interest rates, we do not believe this was coincidental. Higher rates also mean corporate managers should be more disciplined stewards of capital as hurdle rates make for more discerning projects, while earnings growth is poised to be stronger as the U.S. economy continues to prosper.
Finally, equity valuations are poised to improve on the back of not only improved long-term earnings growth, but also as the wretched earnings numbers seen from late 2008 through early 2009 roll out of the cyclically adjusted price-to-earnings ratio (i.e., the CAPE ratio). To be clear, this does not mean public markets will go gangbusters, but our expectations are improved, especially after a year like 2018.
Of course, the following risks could tip the economy into a more prolonged downtrend than expected.
Federal Reserve Interest Rate Policy
The most notable risk is the Federal Reserve increasing rates too quickly. This was another potential catalyst in the December equity market selloff and yield declines, with markets telling the Federal Reserve it had moved interest rates far enough. There is an old saying: “Bull markets do not die of old age but rather by central bank tightening.” A quick ascension in interest rates was a big factor in pricking the housing bubble in 2006; the federal funds rate grew from 1% to 5.25% in a little more than two years.
While we are not experiencing that rate of change today (it has been around 0.75% per year over the past three years), the Federal Reserve does run the risk of moving too quickly. In hindsight, it may have been better to begin earlier and raise rates more slowly. For example, given the strong growth in 2013, perhaps starting with 0.25% and moving another 0.25% in 2014 would have been more effective, allowing the economy and the market to get used to the idea. Now, it appears the equity markets may have gotten ahead of themselves, leading to volatility as rates normalize. As American economist Hyman Minsky famously stated, “Stability begets instability.” Said differently, a larger level of stability will generally lead to a larger mean-reverting level of instability.
Recent flattening and slight inversion at the lower end of the yield curve has some fearing the bond market is forecasting a recession. We do not believe this is the case. If a recession is to occur, we believe it will manifest itself in an inversion in different durations. In fact, as shown in Figure 8, the yield curve has historically proven it can stay flat for a long time before inverting.
The market’s outlook seems to be different from the Fed’s; interest rates fell on the Fed’s December announcement, indicating the market is not willing to tolerate any more hikes. In other words, the yield curve is telling the Federal Reserve that rates are closer to neutral than it may think. What this means for future hikes remains to be seen. Dovish comments made by the Fed while hiking rates in December indicate it has adjusted its outlook to two rate hikes in 2019 versus the previously forecasted three to four hikes. Additional statements indicate it may be inclined to make further revisions, as necessary.
Again, recent events do not signal the end of the hiking cycle is upon us; rather, they indicate the market would like a pause in Fed activity. Recency bias would lead investors to conclude a pause could mark the peak of this hiking cycle, but this is not historically the case. As shown in Figure 9, there are examples of a pause or even a modest decline in the federal funds rate before resuming hikes. As illustrated, there also were no recessions after hike slowdowns.
Inflation can be a funny thing. Many people clamor for it, do not really know it when they see it, and then feel buyer’s remorse when they get a potential whiff of it. Until the recent steep decline in the price of oil and other commodities, there was concern inflation was beginning to rear its ugly head. The reality is we have experienced a lot of inflation over the past ten years if we look at asset prices, but no one is concerned when asset prices rise above intrinsic value on the back of lower-than-normal interest rates. However, with interest rates normalizing, investors are starting to fear the corrosive effect of inflation on corporate margins and household wealth.
The trickle down of corporate revenues to wage growth is the first step in bridging the disconnect we have seen between “Main Street” and “Wall Street” over the past ten years. Of course, we do not want wage pressure to get out of hand, as it would put a damper on corporate margins and likely lead to a reversal of unemployment declines. A bit of inflation at the bottom end of the corporate ladder is ultimately a good thing for the American economy in terms of spurring monetary velocity across a greater swath of income brackets.
As such, we do not think there should be concern at this point if corporations give a portion of their amped-up margins to employees in order to boost retention. While this may cause an adjustment in equity markets, we would not expect such an adjustment to be long-lived, assuming companies can continue to grow revenues on the back of a working population which suddenly finds itself able to spend more than in the recent past. Provided the Federal Reserve unwinds its balance sheet in a methodical manner, interest rate increases should remain contained and the economy should continue its positive growth trend. After all, the economy has never gone into a recession with a real federal funds rate of 0% (Figure 10), which represents its current level. We would feel more at ease if long-term rates would resume increasing, not only to steepen the yield curve but also to reflect the bond market’s perception of higher growth. That said, we know never to say never, but we think it wise to rely on historical patterns; at present, signs are not pointing to a recession or an imminent bear market.
There are concerns given the standoff we continue to see between the U.S. and China, but the magnitude of the proposed tariffs continues to be outweighed by the magnitude of the tax relief provided by the Tax Cuts and Jobs Act of 2017. Were this to change, we would reassess our position. Thus far, however, trade war concerns have had a disproportionate effect on the price of Chinese stocks versus U.S. equities. It is important to keep in mind that average tariff rates in the U.S. remain well below historical standards. This does not mean there won’t be fallout, but at this point we believe tariff-related volatility will be more bark than bite.
Slower-than-Expected Earnings Growth
We are currently seeing the potential for a slowdown in earnings growth rather than earnings declines. This is a substantive difference, one which could define the gap between a garden variety equity market correction devoid of recession and a difficult bear market featuring an economic recession. History suggests a slowdown without negative growth is a fairly common occurrence as companies right-size their businesses for a continuation of profitability.
Unfortunately, our experience over the last 20 years reveals when growth slows, it turns negative. This has not always been the case, and at this juncture, signs point to a potential slowdown being just that—a modest slowdown, not a pullback. What it does mean for equity markets, however, is that multiples contract as investors are less willing to pay up for earnings streams. While current conditions may not necessarily translate into a substantive bear market, there is potential for a rolling bear market to persist as correlations decline and we see greater return differential among various sectors rather than a one-direction-fits-all market.