It’s still a slow growth environment. Inflation is low. Investors can expect continued performance dispersion.
Employment is off the table for the Fed
As mentioned in our earlier video blog the November employment gain of 211,000 combined with the upward revisions totaling 35,000 for September and October certainly took the employment issue off the table as a showstopper for a Fed Funds target rate hike this month. There are very few categories where the actual unemployment rate is above the 5.0% rate for the overall workforce: teenagers at 15.7%, blacks at 9.4%, Hispanics at 6.4%, those with less than a high school diploma at 6.9%, those with only a high school diploma at 5.4%, and I would highlight mining at 8.5% (versus 2.8% a year ago). I would posit that these levels are not the responsibility of the Federal Reserve to deal with. And, what is going on in the mining sector, which includes oil and gas extraction, may have added to the employment roles in other categories as lower energy prices increased both consumption and most companies’ (ex-energy’s) profit margins. The November beige book and the latest JOLTS report point to a tighter labor market with increased difficulty filling jobs and quit rates high, which point toward an increase in wage rates. The Fed does have to look at a tight labor market and make some judgments regarding this ultimate impact on inflation and the pace at which its 2% target is achieved.
So what about inflation?
The Fed’s preferred measure of inflation is the core personal consumption expenditure (PCE) index. That index is up only 1.3% year-over-year and was actually flat month-over-month in October. The general belief is that the US inflation rate may stay lower longer given the expected slow pace of global economic growth, the strong dollar and continued technological innovation. One cannot ignore the tragic events in Paris and San Bernardino as having an impact—on the margin, of patterns of consumer spending and, possibly, levels. This is likely to keep the Fed on a very slow path of target rate increases extending the runway for slow but steady real and nominal growth. I think this path will be followed until inflation actually picks up. I have some views on the timing of this, which I have been saving for this year’s Perspectives piece “What to Expect in 2016 (and Beyond),” but will provide a preview in a separate blog as a wild card to watch for.
And what about the markets?
In turn, these economic and financial results will likely produce slow growth–matching nominal GDP–in the US stock market if valuations stay close to current levels.
The fixed income markets, on the surface, could also appear somewhat benign with a moderate increase in overall rates. No doubt, the slower pace of growth will produce specific credit issues—certainly in energy, but likely some other entities—but credit overall, may hold up reasonably well. The credit markets, at the moment, would appear to be pricing a broader disaster, particularly in the high yield markets. I think we will see some specific disasters—credit issues, but decent credit analysis can eliminate or reduce the impact. An actively managed portfolio in high yield could be a logical allocation to a portfolio.
Odds are some of the longer term trends in currency, commodities, and relative market performance will continue for awhile with some bumps along the way when markets misread central bank actions or statements (à la Draghi) or geopolitical events cause temporary disruptions.
So, how should one invest?
In the table below, which looks at performance of the S&P500 over the last several years, an interesting pattern emerges:
When the market has been up or down double digits all one really had to do was either own or sell the whole market. However, when we have experienced single digit performance for the overall market, much as we are seeing this year, there has been significantly greater dispersion among stocks. This is an environment we expect to continue for some time—slow nominal growth in the economy and the equity markets, leading to dispersion of performance tied to active company management and active investment management. Why do we expect slow nominal growth to persist for several years making active management more important? There are at least four reasons (and I am sure some others):
- As Eric Peters of One River Asset Management recently reminded us, when the Fed takes action, which is typically designed to reduce the magnitude of an economic decline or surge, it has an effect on future patterns of growth. Easing pulls growth forward, while tightening pushes growth out, reducing the depth of the valleys and the height of the peaks and the distortions in employment and inflation those produce. We have been through an extraordinary pulling forward of future growth and it will take time for us to return to normal.
- The debt burden incurred by sovereign nations has been and continues to be enormous. If nothing else this will affect fiscal policy as the tool it could be to add to growth opportunities.
- China’s transition from a global engine for industrial production and consumption to a more internally focused services economy, combined with the reversal of its own extraordinary steps to offset the impact of the western world recession—just look at the production and pricing of hard commodities beginning in 2009—will be a damper on global growth for the foreseeable future. This bears watching to see how closely the yuan continues to track the dollar, or if its inclusion by the IMF as a reserve currency leads to a tracking of a basket of currencies and a different interest rate regime.
- Without putting too much weight on it, the “Buffett Rule”—future equity growth is problematic for a number of years when the total market value of equities exceeds the value of GDP—is operative. I discussed this anecdotally in a recent post.
In a slower growth environment the likely dispersion of equity returns would push one away from index-hugging strategies toward active managers both long only and long/short managers. We have been suggesting this for a while. We would include private equity allocations in the active long only category if immediate liquidity is less of a need and the attractiveness of a potential illiquidity premium in a lower growth environment is magnified. We have these more active managers in our stable of funds, but others do as well. The key message is to adjust allocations to include more of these active strategies in the portfolio as one looks at the environment ahead.
In the fixed income space, while there is risk of rate volatility affecting all debt classes, as big a risk would appear to be more specific credit issues. Does that mean one should be moving up the credit curve? I think the answer is in part, “yes.” But, the preferred way to do that would be similar to the approach on equities: Look for active managers—not benchmark huggers—who are analyzing specific credits and taking advantage of the homogenization of yields that comes from index buying and selling. The high yield index is offering a fairly significant yield spread over treasuries—very tempting as a category. But, just remember that around 18% of that index is in energy and hard commodity bonds. As shown below, the rest of the index, while at lower yields, is at spreads we haven’t seen for almost three and a half years. Historically, in a different energy regime, the rest of the index used to trade at higher spreads than oil and metals.
At this stage, I would rather have someone looking at individual securities making up a diversified portfolio where the detailed analyses show relatively lower credit risks in the environment we foresee. Who knows? There may even be some energy credits that are worth holding but have been tarred by association. We see that in our own portfolios. There are certainly some credits in both high yield and investment grade where the credit default swaps don’t fully reflect the degree of risk at this stage. I want managers who are running portfolios where they can tell me the precise nature of the balance sheets of their individual holdings and the risks associated with the businesses. This is different from what has been required previously.
One should not ignore the uncorrelated strategies, particularly systematic trend following. There are some long-term trends in place. While there are likely to be occasional reversals—some of which could turn into more permanent moves, I would rather use these managers to recognize the patterns and determine which foreign exchange, commodity, equity and fixed income indices should be included, negatively or positively, in the portfolio at any given moment in time given the environment we are facing.
Allocations need to change
It is hard to determine in isolation what the allocations in a specific portfolio should be. That requires a discussion. I know the allocations to active strategies should be higher. As I have been saying, past performance may not be the best guide for the future as opposed to a realization of a different pattern of future returns and an understanding of the volatilities and risks that exist in the environment we foresee. It is a less easy environment, with lower overall returns, but possibly a broader set of opportunities to meet one’s specific goals.