On behalf of the Altium Investment Committee;
The markets have been relatively quiet as compared to the first two quarters of the year. The “status quo” continues for the most part. Stocks have drifted higher and bonds prices have been flat since June, commodity prices have given up a portion of their first half of the year gains, the U.S. $ has been a little weaker while the Japanese yen has been a little stronger, the weather has been a little hotter and drier than normal and not much else happened. Uneventful as it might have been, we certainly hope that you and your family had a good summer.
Stability however is not to be confused with sustainability. Global growth is just fast enough to avoid stall speed, but we haven’t been able to identify a source of productivity or organic demand that would support the case for a more robust expansion. Growth prospects, measured by GDP, in the U.S. remain in the +1 ½ to 2% range, while in Europe and Japan growth continues to languish at +1/2 to 1%. China is still reporting 5-6% growth, but economists’ confidence in that number is low. No imminent global recession seems likely, but the pace of economic recovery remains mediocre. Equity investors don’t seem overly concerned. They remain complacent in the face of increasing valuations, comfortable perhaps in their belief that they are playing “the only game in town” and that there is enough money on the sidelines that could come into the stock market to keep it at historically high levels.
Stability also has a lot to do with a belief on the part of market participants that central banks can continue to steer a course that maintains the “status quo” and achieves growth and inflation targets. Yet a number of market pundits have questioned whether or not global monetary policy has reached a dead end. In fact, several prominent central bankers have themselves spoken of the limits of an easy money/zero interest rate approach. European Central Bank President Mario Draghi, speaking at a recent hearing of the European Parliament, acknowledged the limits of central bank action when he said “very low rates for a very long time do have side effects that especially affect financial stability”. Bank of Japan Governor Haruhiko Kuroda essentially accepted defeat on the central bank’s fundamental strategy to influence consumer expectation by buying assets (mostly government bonds but also real estate and stocks) when he said on September 26th that “the mechanism of formation of inflation expectations in Japan tends to be heavily influenced by the course of the past inflation rate”. The latest data show core inflation in Japan – all prices minus fresh food- is running at -0.5%, far from Mr. Kuroda’s target of 2%. This is after Japan’s monetary base has nearly tripled to 400 trillion yen (approximately $4 trillion) over the past several years.
Meanwhile, back in the U.S. the Fed clings to its old orthodoxy: low rates will elevate asset prices, which in turn should or could eventually trickle down to the real economy. It talks about “normalizing” interest rates, but only when the data indicates that the real economy is in good enough shape for them to proceed. A potential shortfall to this approach is that zero interest rates could destroy capitalism’s basic business model; where high enough interest rates permit a legitimate return on savings leading to increased consumer spending/investing and allowing banks to lend money at a return that compensates them for the risk they assume when making the loan.
We think that the risk of monetary policy “exhaustion” is higher and the margin of central bank error is thinner than they were in June. When considered in the light of the world’s debt overhang reality, the risk of policy failure does pose a threat to the sustainability of a global economic recovery. The fact that few countries outside of the U.S. and China have room to deploy counter cyclical policies in the event they need to only complicates the scenario.
Our investment committee spends a lot of time thinking about and modeling the implications of various future scenarios for our clients’ portfolios. While we acknowledge there continues to be a risk of upsetting the “status quo”, we remain convicted in our investment strategies. There have been several times this year where one could have lost confidence in the equity markets; particularly the first two months of this year and when the UK voted to leave the European Union (Brexit) in June. However, the subsequent recovery of the market following those periods of concern reinforces the benefits of a disciplined long term investment strategy that does not over react to short term events. The chart below illustrates these 2 specific periods of volatility year to date and subsequent recovery (measured by the S&P 500).
Furthermore, for some clients we believe maintaining an allocation to high quality fixed income assets, such as U.S. corporate and municipal bonds, remains a priority. While overall yields remain low, we remain confident in the portfolio stability that these assets offer. Specifically, U.S. treasuries remain in favor, even with the 10year U.S. bond yielding 1.75%. This compares to global bond yields where 71% of the BofAML investment grade global government bond index is currently yielding below 1% (33% is below 0%). Refer to Appendix B, showing the current yields of 10yr government bonds globally.
For sure there is no shortage of things for us to keep an eye on, particularly with the Presidential race in the U.S. entering its final phase and the Fed poised for its first rate hike this year in December. Based on our assessment of the risks associated with today’s “stable, but not secure” investment climate, we continue to believe that maintaining a well-diversified portfolio is the best strategy for our clients. As always, we’ll keep you informed of our thinking and we look forward to seeing you in our offices soon.
Gregory Slater, CFA, CFP®
Chief Investment Officer
A. 12 month major index market returns; US Equity (Russell 3000); Domestic Bond (LQD); International Equity (EFA)
B. 10 Year Global Government Bond Yields
C. Monthly Asset Class Returns
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