by Asset Allocation Committee

Since the beginning of the year, long-term interest rates have moved higher.  The constant maturity 10-year Treasury yield ended 2017 at 2.40%.  That yield climbed to 2.60% in January, which is above our recently released 2018 Outlook forecast.  We are not adjusting our forecast quite yet because the driving factor behind our forecast was continued flattening of the yield curve.  However, if the curve doesn’t flatten further, we will need to revisit that forecast.

The recent rise in yields has led several commentators to declare a new bear market in bonds had developed.  We sort of agree with this statement; we believe a secular bear market in bonds began in 2016 and we will likely see gradually rising rates for the foreseeable future.  However, the key word is “gradually.”  The last secular bear market in bonds began in 1945 and took over two decades to become a serious problem for financial markets.

The above chart shows the 10-year T-note yield from 1921 to the present.  In 1945, yields made their secular low and gradually rose into the early 1980s.  Note the gradual ascent of yields for the first couple decades.  It wasn’t until yields rose above 5% in the late 1960s that rising rates began to have an adverse impact on financial markets.   Of course, when one is talking about secular cycles that last three to four decades, the last experience may not be indicative of what the current secular bear market will look like.  Fortunately, the Bank of England has maintained long-term databases of British interest rates and can offer us some insights into long-term cycles.  The chart below shows the interest rate of British Consols beginning in 1701.  These instruments were bonds without a maturity; essentially, they were very long-duration instruments.  Note that bull and bear markets tended to last a very long time and, in fact, the British bond bear market after WWII was impressive in terms of rate increases but rather normal in terms of length.

Why do secular cycles in bonds last so long?  For the most part, secular cycles in long-duration interest rates are driven by inflation expectations.  Rising inflation undermines the real value of interest return; investors, stung by inflation, will demand ever higher yields for protection.  When policy changes to corral inflation, it takes some time before investors “forget” their unpleasant experiences and accept a lower interest rate.  After a long period of low inflation, investors are “fooled” by rising inflation, at least at its early stages.  This underestimation in inflation leads to falling real returns and prompts demand for rising rates.

What makes the current period interesting is that the baby boomers are unusually sensitive to inflation fears because most of them spent their formative years during the high-inflation period of the 1970s.  Thus, any signs of inflation, regardless of how minor, tend to lead to “discomfort” in the fixed income markets.  The existence and current prominence of the baby boom generation will likely keep long-duration rates from rising very much in the coming years.  The oldest boomer is 72 this year, while the youngest is 54.  Clearly, over the next two decades, the memory of 1970s inflation will fade and the subsequent generations will be much more likely to be fooled by inflation and will be slow to demand higher yields.  This fact will probably lead to the final stages of the bond bear market, which will be rather painful for investors.

So, what does an investor do in the meantime?  We look for gradually rising rates over time.  The policies of neoliberalism, which supported globalization and deregulation,[1] successfully ended the high inflation period of the 1970s.  We are likely in the early stages of a retreat from neoliberalism.  The rise of populism in the West is partly due to citizens becoming acutely aware of the costs of neoliberalism (high level of inequality and job insecurity) without being aware of its benefits (low inflation, long business expansions).  Although it will take some time, tolerance of higher inflation will likely increase.  Investors have two strategies for such an environment.  First, corporate credit tends to do better in the early stages of a secular bear market because gradually rising prices reduce credit risk as firms find it easier to pass along higher prices.  Second, bond laddering, the purchase of instruments at various points of the yield curve, offers some defense from rising rates.  As time passes, the duration of a laddered portfolio falls, reducing rate risk.  As the nearest instrument matures, the investor buys a longer term instrument and the process repeats.  We are currently deploying both strategies in our fixed income allocations.

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[1] We define deregulation as the unfettered implementation of new technology and methods on the economy.

by Asset Allocation Committee

Last week, we issued an addendum to our 2018 Outlook[1] to take into account the recent tax law changes.  Our top-down analysis suggests there will be a significant increase in corporate earnings which will translate into higher S&P 500 earnings.  Our original forecast was for $129.82[2] for 2018; we have increased our earnings forecast in light of the tax bill to $144.84.  We are assuming a 21.1x P/E multiple for 2018, meaning our forecast for the S&P 500 has increased from 2739.20 to 3056.12.

Whenever we make a forecast, as part of the process, we look for factors that could lead us to be wrong.  In the original 2018 Outlook, we focused on a number of factors, including an unexpected recession, excessive monetary policy tightening, etc.  In our 2018 Geopolitical Outlook,[3] we added other events that could adversely affect this forecast.  In this report, we will focus on another factor that could lead to forecast variance.

One of the goals of the tax bill is to boost investment.  The focus on investment does make sense; since the early 1980s, investment levels relative to GDP have been falling with each expansion.

This chart shows the average level of corporate investment relative to GDP for each expansion since the 1960s.  As noted, the level of corporate investment has been falling with each expansion.  It isn’t obvious why this is occurring—a number of factors are probably involved, including more corporate investment offshore due to globalization, improved efficiency of investment due to technology and less investment due to industry concentration (fewer firms making the same things don’t duplicate productive capacity).  The problem is that these are structural factors and we doubt mere changes to the tax bill will foster a significant boost in investment.

This chart shows capital investment and the level of business saving.  Ample capital investment can occur without business saving; in fact, it is not uncommon for business dissaving to occur during periods of expanding capital expenditures.  The recent rise in business saving coincides with falling levels of capital expenditures.

Cutting corporate tax rates could lift investment if there was a lack of available liquidity because cutting tax rates should lift the level of cash available for investment.  However, there is little evidence to suggest a liquidity shortage.  First, as seen above, flows into business saving have been rising.  Second, cash and near-cash holdings of non-financial corporations is relatively high and well above the trough level seen since 1980.

Current liquid assets relative to total assets are 4.9%, which appears ample for self-funding investment.

Third, and perhaps even more telling, is that commercial and industrial (C&I) loan growth is at a level associated with recession.

The current yearly growth of C&I loans is +0.09%; in the past, this level is usually observed either when the economy is in recession or shortly after one has ended.  In no period during the postwar experience has C&I loan growth been this weak without being associated with a recession.  The reason that slowing C&I loan growth affects the economy is that when commercial banks begin cutting back on loans, it usually lowers investment; at the same time, commercial banks tend to be cautious and don’t begin restricting lending until it is abundantly clear that the economy is weakening, thus making this indicator mostly a lagging one.  Lending surveys from the Federal Reserve do not suggest senior loan officers are tightening credit.  Thus, we conclude that the drop in lending is probably a function of falling demand for the loans—simply put, businesses don’t need the liquidity and aren’t borrowing for the current level of economic activity.

As a result, the corporate sector, which has ample liquidity and isn’t borrowing, is about to get even more liquidity pushed its way.  The key issue is most likely a lack of aggregate demand.  In other words, the economy isn’t growing fast enough to trigger an expansion of the capital base.  Thus, unless other parts of the tax law encourage economic growth, the economic impact from the tax cuts will likely be rather small.

However, the financial impact could be significant.  Expanding corporate liquidity will likely encourage higher dividends, share buybacks and merger activity.  Given the expected boost in earnings from the tax cuts, the expansion of corporate liquidity and the anticipated response from corporations to reward shareholders should support the continued elevated multiple and perhaps even lift investor sentiment further.

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[1] See 2018 Outlook and 2018 Outlook: Addendum

[2] Using Standard & Poor’s operating earnings rather than the more commonly quoted Thomson/Reuters operating earnings, which averages approximately 8% higher.

[3] See WGR, 12/18/17, The 2018 Geopolitical Outlook

by Asset Allocation Committee

Equity markets had a very strong 2017, with the S&P 500 up over 20% for the year.  Earnings rose more than expected, the economy continued to expand and investor sentiment was buoyant, all of which contributed to rising equities.  The tax bill, signed in late December, will give equities a lift going into 2018.  In this report, we will examine equity market behavior as part of the presidential cycle.

To perform this exercise, we look at weekly closes for the S&P 500 starting in 1928.  We rebased the index for every four-year election cycle, so the first year is the actual election year (with elections held in November) along with the next three years of the term.  Using this database, we can sort by incoming party, incumbent party, high correlating terms, etc.  Earlier this year, we published this graph.

The red line on the chart shows the average S&P 500 performance for a new GOP president; the blue line shows the performance during the Trump administration.  From the beginning of 2016 into Q3 2017, the two lines closely followed each other.  However, they have diverged rather dramatically since then.  We suspect that the anticipation of tax reform has led to the sharp rise in equities.

The real question is how will equities perform in 2018?  The tax reductions built into the tax bill will likely have a significant impact on corporate earnings; we will have more to say about that in subsequent reports.  However, another way to look at equities is by comparing the performance of the current Trump term to other four-year cycles.

There are six other periods that correlate at 90% or above.  Three of the six show weakness in the second full year of the administration, 1960-63, 1964-67 and 1988-91.  In the first instance, the Cuban Missile Crisis likely led to the pullback.  The escalation of the Vietnam War and rising inflation (the highest rise in the CPI in nine years) weighed on equities in 1966.  The First Gulf War and the 1990-91 recession were behind weaker equities in the 1988 cycle.  The other three had mostly rising equity values in the second full year of the political cycle.

Interestingly enough, the highest correlating cycle is 2012-15, the second Obama term.  Although the current index is running a bit behind compared to that year, the index pattern is most similar.  If we continue to track that cycle and narrow the gap, the S&P 500 would end up at 3267.65 at the end of 2018.

How is this exercise useful?  This analysis looks at high correlation periods and projects what may occur assuming that no major exogenous events occur.  Obviously, a war or recession would lead to different outcomes.  But, if the U.S. avoids an economic downturn or a major political or geopolitical event, equity markets could have another strong year.

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by Asset Allocation Committee

(N.B. This will be the last Asset Allocation Weekly for 2017.  We thank our readers and wish them a Merry Christmas and Happy New Year.  The next report will be published on January 5, 2018.)

As equity markets continue to trend higher, there are always worries about how long the bull market can last.  In general, bull markets over the past three decades have tended to end with recessions, triggered either by a policy mistake or a geopolitical event.  Unfortunately, the latter are binary events and difficult to predict.  We do pay close attention to such events in our Weekly Geopolitical Reports.

Due to its importance to financial asset performance, we also closely monitor the economy.  One of our more simple indicators is constructed with commodity prices, initial claims and consumer confidence.  We standardize the data and combine it into a single indicator.  The thesis behind this indicator is that these three components should offer clear signals on the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.

The above chart shows the results of the indicator and the S&P 500 since 1995.  We have placed vertical lines when the indicator falls below zero.  Although it works fairly well as a signal that equities are turning lower, it is a bit slow.

To make a more sensitive indicator, we took the 18-month change and put the signal at -1.0.  This triggers a more useful sell signal and also eliminates the false positives that setting it at zero would generate.  However, we do pay close attention when the 18-month change falls under zero.

What does the indicator say now?  Clearly, if we are going to have a pullback, it won’t be from the economy.  The economy is healthy and will be supportive for equity markets.  That doesn’t mean that valuation doesn’t matter, but it does suggest that the economy shouldn’t cause a bear market in the near term.

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