Adopting a More Cautious Stance

We are in a very different place than we were two years ago. In the fourth quarter of 2016, long-term interest rates had just hit a generational low, driven by a flight to safety in the immediate aftermath of the Brexit vote. The corporate earnings recession in which the U.S. had been mired was coming to an end. Earnings and dividend yields looked attractive relative to interest rates and—when combi­ned with a positively sloped yield curve signaling expectations for continued economic growth—stocks looked cheap compared to bonds. On the eve of the 2016 presidential election, investors began to reward this mispricing. As such, when momentum confirmed the opportunity stock markets offered, we moved to overweight equities decisively across our strategies.

Since then, the Trump administration has implemented a raft of policies aimed at increasing economic growth, including deregulation of the financial and energy sectors and, most notably, the Tax Cuts and Jobs Act of 2017. The latter was explicitly designed to induce a supply side stimulus to increase productivity growth and to add to the economy’s capacity to grow at a higher rate sustainably. This, in theory, will increase tax revenue in future years to help pay for the increase in deficits and debt it created.

The economy has grown more robustly in 2018 than it has in recent years. In fact, next summer, the expansion which started in 2009 is set to eclipse the decade of the 1990s as the longest period of uninterrupted U.S. economic growth since the National Bureau of Economic Research began tracking the data back to the 1850s. (Dating back to the Second World War, the modern economy has, on average, experienced two recessions per decade.) This has allowed corporate earnings to boom over the past few quarters, improving stock market valuations through multiple compression. Stocks today are priced to deliver better long-run expected returns than they did a year ago.[1]

Our discipline, however, is telling us a cautious stance is warranted in the near term, primarily because long-term interest rates have doubled to near 3% since 2016.

The Federal Reserve (Fed), under new leadership, has moved to steadily normalize monetary policy over the past two years. If, as markets expect, the Fed again raises short-term interest rates by 0.25% at its meeting this week, rates will have increased a full 1% in 2018. The Fed also continues to sell bonds to reduce its balance sheet which became bloated after years of stimulating the recovery through artificially low interest rates. Federal Reserve Chair Jerome Powell (the first person not from academia to occupy the role since Paul Volcker in the 1980s) is more skeptical than his recent predecessors about the Fed’s ability to fine-tune the economy. In order to build up ammunition for when the next downturn finally arrives, Powell’s Fed is anxious to normalize monetary policy through higher interest rates while the economy remains strong.

Higher long-term interest rates have made it harder for corporate earnings to grow and boost stock markets in the near term. The yield curve has flattened—and it has even inverted between the 2- and 5-year maturities—which is a signal from the bond market that the Fed has run out of time to further normalize monetary policy. Additionally, rate-sensitive sectors, such as the housing and automobile markets, have slowed significantly, suggesting past interest rate increases have already started to take effect.

Other areas of capital markets are providing telltale signs the economy is moving to a softer period of growth in 2019. Credit spreads have widened—albeit off a historically low base—across all sectors, suggesting corporate America is finding it more difficult to finance its activity from non-bank lending. Commodity markets have rolled over, reflecting the pressure the emerging world is experiencing as a result of ongoing concerns that 2018’s trade war may devolve into a longer, new “cold war” with China. If the trend of the globalization of the world economy, which helped to contain inflation for so long, begins to reverse next year, it would make it more difficult for policymakers to secure a “soft landing” of positive growth at a lower rate.

As a result, unlike the summer of 2016, stocks now look relatively expensive when compared to fixed income. Momentum behind the stock market has slowed sharply since the long pause for breath it took during the first half of 2018. When taken together, we decided at the end of November to take a more cautious stance across all investment strategies. Importantly, the signal we are receiving is not suggesting we are on the precipice of a deep and extended bear market such as the bubbles which burst in 2000 or 2007, but, as always, we are monitoring developments closely.

[1] The 2019 edition of our annual Capital Markets Forecast will be available in February.