MARKET COMMENTARY

The Past Is Prologue: A New Chapter in the History of Financial Markets

03.22.2018 - Ronald J. Sanchez, CFA

Investors may need to prepare for a shift in trends that have been in place for much of this cycle.

KEY TAKEAWAYS
  • Stock and Bond Correlations 
    In a normal market cycle, stocks and bonds may move in opposite directions and there is a wider degree of dispersion between winners and losers. As the era of financial repression fades and fiscal policy takes the reins, this traditional relationship could return.
  • Volatility Returns to the Market 
    Stock market volatility and performance could return to levels that more closely resemble historic norms. While market turbulence may seem unfamiliar to investors after the unusual tranquility of 2017, it is not uncommon over the course of a traditional market cycle.
  • Growth Versus Value
    Growth stocks have outperformed value stocks by nearly 100% since 2008, but in this new environment the gap between growth and value returns could moderate.
  • Active Versus Passive Investing
    The lines distinguishing winners from losers in the stock market will become clearer. So, “owning the market” in a passively managed index fund could be less effective.
  • Alternative Asset Classes
    As interest rates rise and stock market volatility picks up, hedge funds and other alternatives could see new opportunities to generate alpha and reduce portfolio volatility.

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Notable changes in the global economy are rising to the surface and influencing the financial landscape in ways that are both profound and likely to persist—they could have implications for investors for many years to come. 

As we enter a new chapter in the history of financial markets, we appear to be transitioning away from the meager economic growth and emergency monetary policy that has dominated markets since the global financial crisis (GFC). The destination is uncertain, but one thing is clear: The environment we encounter will bear little resemblance to the one we have seen for the better part of the past decade.

To understand where we’re going, it’s important to understand where we’ve been.

Goldilocks Arrives

By the time the GFC reached its peak, US policymakers had already taken the first steps toward an intervention program that would eventually flood the market with liquidity. In an attempt to jump-start a flailing economy, the Federal Reserve started aggressively buying US Treasury bonds and mortgage-backed securities on the open market, and cut the policy rate to 0% for the first time in history. However, these policies were more effective at lifting financial markets than stimulating economic growth.

Ultimately, the Fed’s extraordinarily accommodative policy, combined with muted economic growth and low inflation, created the ideal environment for equity and fixed income markets. In the US, over time, investors became willing to pay a premium for corporate earnings growth, and valuations ascended to levels that exceeded long-term averages. In a development that is uncharacteristic but not unprecedented, stock and bond markets moved higher in tandem, while volatility in both markets dissipated—creating a Goldilocks environment for the markets.

Goldilocks Departs

It appears to us that this Goldilocks environment is shifting due to two key developments that have emerged over the past 18 months: Global growth has resynchronized and broadened out, meaning the US is no longer the sole driver of economic growth. And the US has embarked on an aggressive agenda of fiscal policy, marking a distinct shift from the prior decade of emergency monetary policy.

For much of the post-GFC era, the US led the global economy with tepid, but steady, GDP growth. That leadership role started to fade in mid-2016 as international developed and emerging economies gained some long-awaited traction. Despite headwinds, they expanded at a pace that eventually equaled or exceeded the US’s muddle-through growth rate of 2%, ushering in synchronized global economic expansion (CHART 1). In addition to relinquishing its role as the sole driver of global growth, the US has benefited from this development, enjoying the strongest economic growth since 2015.

Simultaneously, as the Fed moves toward reducing its massive balance sheet and normalizing its target policy rate, legislators have been busy cutting corporate taxes, offering incentives for capital expenditures and approving a new federal budget, including $300 billion in new spending and an additional $200 billion in proposed infrastructure projects. 

This distinct shift in government policy from monetary to fiscal stimulus will likely have sustained implications for the economy. As a result of this new direction, the benign inflation backdrop that has been entrenched for nearly a decade may finally be coming to an end.

Heading in the Direction of "Normal"

So far, this discussion has focused primarily on changes that are concrete and demonstrable—things we already know are happening. There are also several changing dynamics worth exploring that could strongly influence the economy and markets. They are all inextricably linked.

Inflation May Finally Be on the Horizon
After nearly a decade of ultra-easy monetary policy, the Fed has achieved near-full employment. However, it has been less successful at promoting price stability. Its preferred gauge of inflation, Core Personal Consumption Expenditures, has consistently fallen short of the Fed’s 2% objective (CHART 2).



This inflation dynamic extends beyond just goods and services and beyond the US. Average hourly earnings, a widely used measure of employee wages, typically reaches a growth rate of 4% per year by the end of an economic growth cycle. But the last time wage growth exceeded 3% was 2009. Since the passage of tax reform in December, anecdotal evidence suggests that a number of large companies are raising wages, and government reports on wages and job “quit” statistics suggest competition for workers is heating up.

Of course, inflation is influenced by other factors beyond monetary policy. Huge secular headwinds from globalization to technological innovation have helped keep a lid on inflation. But with the emergence of fiscal policy, cyclical forces could meaningfully lift prices for the first time in a decade. Still, we believe inflation is unlikely to spike sharply or escalate in the near term to levels seen in previous market cycles. 

While emergency monetary policy may have fallen short of achieving price stability and robust economic growth, a combination of these forces has created a backdrop for bond investors that can only be described as nirvana. As we depart from the era of emergency monetary policy and migrate into a world where economic growth and inflation are bolstered by fiscal stimulus, this backdrop will likely fade.

Deficit Spending Complicates the Picture for Bonds
The US government is spending more at a time when tax reform could mean less income. This dynamic has significant ramifications for the federal deficit and, ultimately, fixed income markets.

On the supply side, tax reform has created a considerable near-term budget deficit that the US government will need to address by issuing more Treasury bonds. As a result, Treasury bond issuance in 2018 and 2019 could reach twice the level seen in 2017. 

On the demand side, we see three main challenges: Investor appetite for risk-free assets, which was insatiable during the Goldilocks environment, may moderate. Demand for Treasuries could be further weakened as the Fed tries to reduce the size of its balance sheet from a peak of $4.5 trillion down to something in the neighborhood of $2.5 trillion (CHART 3). And as central banks in other developed markets inch closer to unwinding their own ultra-accommodative monetary policies, their own sovereign debt might look more appealing.



This regime change has meaningful long-term implications for the Federal Reserve and direction of monetary policy in the US. If fiscal stimulus adds even a temporary additional thrust to economic growth, concerns about an “overheating economy” may begin to rise. This is a concern that investors and policymakers have not encountered for more than a decade, and it could put the Fed in a position where missteps are more easily made. If its inflation and growth targets are achieved or even exceeded, the Fed may have to consider adjusting its policy course.

This scenario—in stark contrast to the last decade, which was characterized by 2% real GDP growth, benign inflation, extremely accommodative monetary policy, and less extreme deficit spending—would be far less idyllic for fixed income investors.

Equity Market Valuations and Volatility
Low rates and inflation have not only been extremely favorable for bonds, they have also been good for stocks. So, a shift in this backdrop could have implications for stock valuations. Any hint of stronger-than-expected inflation can constrain stock valuations, placing the burden for growth squarely on the shoulders of corporate earnings.

It has also been suggested that the stock market may face headwinds if US 10-year Treasury yields rise to a certain “magic level.” While we agree that absolute bond yields influence stock market valuations, to a point, we are convinced that two other factors are more meaningful: the forces behind rising yields and the pace at which they are increasing. If an expanding economy and consumer demand drive inflation, rising yields should not be terribly concerning. But if inflation rises without a commensurate increase in consumer demand, valuations could be affected.

February’s market pullback and the turbulence that followed gave us the first signal that we have reached the end of the extraordinarily calm market environment that has been in place since the presidential elections in November of 2016. 

While this unprecedented atmosphere of lofty returns and absent volatility may be behind us, we do not think that means the end of the road for equities (CHART 4). In fact, strong prospects that corporations can continue to grow profits and the global economy can continue to strengthen, favor equities over fixed income. 

The distinction between the last few years and the next is that the near-perfect financial conditions that pushed equity and bond market volatility to  an all-time low are unlikely to persist.



The Bottom Line: Financial Conditions Are Changing
Last year, nearly all of the forces that contribute to financial conditions were favorable for markets. Interest rates in the US barely moved, tighter credit spreads mirrored confidence in the economy, stock prices soared and the dollar weakened. To the contrary, this year we have already seen rates rise, credit spreads widen modestly and stock market returns moderate. In fact, the lone variable helping financial conditions in 2018 is a further weakening of the dollar.

The US economy and financial markets are drifting away from the extremely unusual conditions we have experienced for the past decade and moving in the direction of an environment that more closely resembles a pre-crisis “normal.” Their ultimate destination is unknown. But we have reached a turning point: The global economy is no longer in an apparent state of malaise and the Fed is no longer fueling ideal financial conditions with extremely accommodative monetary policy.



This communication is intended solely to provide general information. The information and opinions stated are as of March 22, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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