Capital Market Outlook (JANUARY 14, 2019)

In This Issue

MACRO STRATEGY

Federal Reserve (Fed) policy is under review as Chairman Powell backs away from previous hawkish commentary. Consensus economists and the Fed thought leaders assumed inflation would rise with wages. This flawed model has misled them. Instead, supply-side productivity gains and restraining monetary policy have created a sharp deflationary shock. As a result, the Fed has fallen short of its inflation target for the tenth straight year.

GLOBAL MARKET VIEW

By imposing tariffs on a wide range of Chinese imports and threatening other market-restricting measures, the U.S. smashed a lot of china in China in 2018. Growth in China has slowed significantly due in part to trade tensions with the U.S. A truce on trade seems imminent, with both sides needing a deal, since the more the bull rumbles in China, the greater the downside risks to global equities.

THOUGHT OF THE WEEK

Another round of turbulence struck financial markets during the fourth quarter of 2018, as economic data continued to signal a softening of global growth, along with a continuous removal of monetary stimulus and liquidity from the Fed. Here we outline the status of the key drivers of the market as we progress through 2019.

PORTFOLIO CONSIDERATIONS

We are maintaining our overall absolute equity allocation across all risk profiles. However, we are lowering our non U.S. developed equity allocation and adding to U.S. large cap equities. We maintain our risk exposure in emerging market equities.

Macro Strategy

Anatomy of A Monetary Policy Mistake

Chief Investment Office Macro Strategy Team

Monetary policy mistakes are inevitable. The economic theory behind policy is far from perfect and often difficult to implement. As a result, tightening and easing cycles tend to go too far relative to policy objectives until it becomes apparent that enough is enough. At his appearance before the American Economic Association conference in Atlanta on January 4, Fed Chairman Powell essentially admitted that the Fed had reached such a point in its latest tightening cycle. This sparked a major risk-on rally in markets, typical of the end of bear markets when Fed policy finally stops tightening.

The Fed's ostensible goal in raising its policy rate from 12.5 basis points as recently as the fourth quarter of 2015 to 237.5 basis points at its December 19 meeting was to "normalize" rates around neutral levels after the extraordinary period of zero interest rates and quantitative easing that followed the financial crisis a decade ago. The strengthening U.S. economy no longer needs the emergency easing that helped end that crisis in our opinion.

In addition to the rapid rise in short-term interest rates over the past two years, the Fed has begun to shrink the monetary base by reversing the quantitative easing that swelled base money from less than a trillion dollars before the collapse of Lehman Brothers in September 2008 to a peak just shy of four trillion dollars in November 2017. Since then, quantitative tightening has shrunk the monetary base by roughly 16%, according to Haver Analytics, by far the biggest decline since World War II. Policymakers have minimized the supposed impact of this shrinking monetary base, but increasingly market observers are expressing concern over its contractionary impact on global liquidity. For example, recent calculations by researchers at Gavekal Research find the world monetary base adjusted for inflation has contracted by about 8% over the past year, the most since the early 1980s with the single exception of a similar contraction in 2015–2016. Early evidence that a major deflationary shock from central banks is starting to develop based on the sharp cumulative contraction in the real global monetary base since the Fed began to raise rates in late 2015.

In theory, a shrinking monetary base need not be restraining if the money multiplier rises to maintain growth in the money supply and/or the velocity of money picks up enough to offset the restraining effects of slower money-supply growth. In practice, we have seen a sharp deceleration in the growth of both M1 and M2 measures of the money supply during the quantitative tightening of the past two years. Year-over-year growth in M1 has shrunk from roughly 8% in the year up to the peak in the Fed's balance sheet to just 3% in the latest year. Growth in M2 has dropped from about 5% to just under 4% during the same period.

Interest in growth in monetary magnitudes has reached a low point in recent years after peaking in the early 1980s, when Paul Volcker began the process of targeting the money supply rather than interest rates to bring down inflation from double-digit levels. Volcker's tighter grip on the money supply started the long disinflationary trend of the past four decades. As an operating procedure, strict money-supply targeting proved disruptive to financial markets because it caused interest rates to gyrate in an unprecedented fashion. Since the Fed operates through money markets in the banking system, interest-rate targeting is a more natural procedure for monetary policy and has generally been the modus operandi of central banks over the years. Volcker's money supply targets were an unusual exception that worked to reverse the inflation trend but were generally judged a failure because of the disruptive and volatile nature of their impact on financial markets in the short term. Since then, economists have largely been dismissive of monetary aggregates as a useful gauge of policy. This is especially apparent in current Fed views about the relative insignificance of quantitative tightening for achieving its policy objective. That objective is to seek a 2% inflation rate over time, with inflation defined as the "core" personal consumption expenditure (PCE) deflator. The last time the Fed hit this inflation target on a calendar year basis was 2008.

Since the financial crisis delivered its huge deflationary shock, the Fed has undershot its inflation target for ten straight years. The "core" PCE deflator has averaged about 1.5% over the past decade. As it has appeared to approach the target, most recently this year, the Fed has felt the need to tighten. The overwhelming evidence since the financial crisis is that the Fed and other major economy central banks, most notably the European Central Bank (ECB), have been too quick to jump the gun and reverse easy policies before inflation got sustainably to the target level.

Arguably, the most flagrant example of this excessive zeal to tighten was the colossal error by the ECB in 2011, when it jumped the gun by tightening and put Europe back into a double-dip recession from which it has struggled to recover. While the Fed has fallen short of its inflation target for a decade, the ECB has missed by even more. And then there's the Bank of Japan, which, after missing by the most, is now the only major central bank pursuing a credible policy to hit its target. The Fed, unfortunately, has imparted a big deflationary shock to the U.S. economy just as it approached its inflation target for the first time in a decade.

Inflation Is Always and Everywhere A Monetary Phenomenon

While Volcker's experiment with monetary targeting was regarded as too disruptive for financial markets because it resulted in extreme interest-rate volatility, it did work to stop the progressive ascent of inflation, which was the most pressing issue at that time. As inflation has come down over time, so has the interest of economists in the decisive role that money plays in creating inflation.

The ascent of inflation had been facilitated in the 1960s and 1970s by the prevailing view among economists that expansionary monetary and fiscal policies would be able to keep unemployment low at a relatively minor cost of tolerating higher inflation. Just as that view was taking practical hold of policy, Milton Friedman, 1976 Nobel Memorial Prize recipient in Economic Sciences, was developing the underlying theory that forecast the stagflationary consequences of the mainstream view driving policy.

Called to service at the peak of the stagflation debacle, Paul Volcker used Milton Friedman's insights to cure the problem.

First, in his monumental "A Monetary History of the United States" with Anna Schwartz, Friedman had showed how business cycles in the U.S. were always associated with accelerating and decelerating movements in the money supply. He also used cross-country and historical evidence to illustrate how inflation and deflation were purely monetary phenomenon rather than functions of real factors like the unemployment rate, technology or other non-monetary phenomenon.

In addition, he predicted the coming stagflation problem in his 1967 presidential address to the American Economic Association. He explained why the prevailing Keynesian, Phillipscurve view would lead to long-term instability and higher unemployment despite temporary short-term gains in growth and employment. The stagflation of the late 1970s proved his point, and the Fed (and other central banks) began the long-term process of unwinding the damage from the misguided Keynesian polices.

From a monetary policy perspective, the blind spot in not recognizing the role of the money supply in creating inflation led to the Fed continually falling behind the curve in controlling inflation in the '60s and '70s. The focus on interest rates meant the Fed would raise rates to curb inflation. However, inflation expectations were spiraling up, as Friedman had predicted, so that inflation and money-supply growth outstripped the impact of rising policy rates as people started to assume inflation would more than compensate for higher rates. In other words, while nominal rates rose, real rates were falling because inflation rose faster. Volcker's incorporation of Friedman's ideas halted this stagflationary spiral.

Flash forward to today, when we have the opposite problem. Instead of worrying about bringing inflation down to a reasonable target, central banks are struggling to get inflation up to a target that will minimize deflationary risks in a highly leveraged world. Instead of constantly underestimating the appropriate level of interest rates that will rein in inflation, central banks have been constantly overestimating the level of interest rates that will allow inflation to range symmetrically around 2%.

This overestimation of the so-called neutral rate is apparent in Exhibit 1, which shows the Federal Open Market Committee (FOMC) estimates of the interest rate that it believes will see a 2% inflation target over time. From about 4.25% in early 2012, the median estimate has come down to less than 3% recently. Market reaction, including the yield curve flattening in 2018, suggests that the FOMC is still overestimating the neutral rate.

Various measures we use indicate the Fed passed neutral and became mildly restrictive when it raised the funds rate above 2%. In short, the last two rate hikes and the Fed forecast for more in 2019 were restrictive enough to raise legitimate concerns that the Fed would cause a recession. The contractionary impact of quantitative tightening on the money supply adds to the disinflationary effect of the Fed's current policy.

Exhibit 1: Fed Has Overestimated the Neutral Rate and Missed Its Inflation Target as a Result.

Now that the Fed is beginning to acknowledge these concerns, the markets are showing relief. It's clear to us that the key to an optimistic outcome is a focus on inflation rather than the unemployment rate and wages. Falling unemployment and rising wages are not causing inflation to increase. Instead, stronger productivity and tight monetary policy are causing inflation to fall. In his December 19 press conference, Chairman Powell seemed oblivious to this. That caused the markets to riot. The Fed needs to focus on inflation and stop attacking the improving labor market in our opinion.

Global Market View

America: The Bull in The China Shop

Since becoming president, Donald Trump has broken a lot of china. In short order, President Trump has pulled the U.S. out of the Trans-Pacific Trade pact and the Paris climate agreement; shaken the foundations of the global trading system by instituting tariffs on steel and other goods while threatening even more trade restrictions; and up-ended relations with traditional allies, like the European Union, and foes like North Korea. Chiding Federal Reserve chairman Jerome Powell for raising interest rates, encouraging U.S. firms to invest at home, insisting on "the Wall," shutting down the government—all of these norm-breaking activities have helped define one of the most unconventional administrations of the modern era.

For better or for worse, a lot of china has been broken since the 45th president took office nearly two years ago. But we're not just speaking metaphorically. We are speaking literally as well.

There is truly a bull in China's shop—it's the United States.

Past Is No Longer Prologue

China has spoiled investors for decades. By making 10% per annum economic growth look easy for decades, by lifting over 300 million people out of poverty since 1980, by emerging as an export juggernaut and the world's largest creditor nation, China has long been a steady anchor of the global economy. Since the world emerged from the Great Recession of 2008/09, China has been a main contributor to the growth in global output.

But past is not prologue. Investors need to be prepared for a different China in the future. The world's second largest economy has entered a new era of growth and development, one that has the potential to result in annual real growth of less than 5% over the medium and long term.

This transformation will be a multi-year process and one that will not be easy to achieve for a number of reasons. Breaking the habit of export- and investment-led growth means running headlong into vested interests (think coddled state-owned enterprises, and heavily indebted local provinces and municipalities). Shifting toward a more market-oriented exchange rate and opening the capital account comes with considerable risks—namely the prospects of soaring capital outflows and the attendant depreciation of the currency, two headwinds Beijing is struggling to counter. And finally, if the challenges mentioned weren't enough, China confronts a prolonged and fractious period with the one country in the world that not only has the economic and military firepower to forestall the rise of the Middle Kingdom but is also determined, at least on the surface, to do just that: the United States.

The Clash of The Economic Titans

By imposing tariffs on nearly half of all Chinese imports to the United States and threatening even broader restrictions by March 1; by calling out China for not abiding by the general rules of the World Trade Organization; and by tightening restrictions on Chinese investment in the U.S., the Trump Administration has broken a lot of china in China.

China, in our opinion, is not headed for recession but the adversarial bi-lateral stance of the U.S. has contributed to the country's weaker-than-expected growth heading into 2019 and, by extension, the downdraft in global growth over the past few quarters. As Exhibit 2 highlights, no two countries exert as much influence on global trade as the United States and China, with both critical markets for the world's exporters.

Exhibit 2: Trading Places? Countries with U.S. & China as Top Export Partner.

That said, the American bull in China's shop has weakened many Chinese producers by boosting their costs and reducing their orders due to U.S. tariffs. Many Chinese firms, in response, have had no other choice but to cut capex spending and lay off workers; some have opted to push production to lower-cost, less politically sensitive economies like Vietnam and Cambodia, boosting manufacturing unemployment across industrial China. Fears over trade have also helped soften the property market and battered Chinese equity prices, creating a negative wealth for many Chinese consumers and an attendant softening in consumer spending. To wit, automobile sales in China declined last year for the first time in over two decades, although an auto tax contributed to the downturn.

The nation, meanwhile, remains stuck in "middle class" status, with diminished odds of moving up the development ladder given the mushrooming confrontation with the United States. In addition, with growth slowing and the government in the "whatever it takes" mode to keep the expansion alive, the country's goal of "high-quality" economic development has been pushed to the sidelines. Structural reforms (including financial sector liberalization, cracking down on the shadow banking industry, opening the capital account, internationalizing the currency) remain a priority but have been downgraded as Beijing adjusts to a global trade and financial environment far more inimical to the long-term interests and goals of the nation.

The upshot from all of the above: The bull (America) has done significant damage to China's near- and long-term growth prospects. By the same token, however, the bull has been bloodied.

TRUCE?

Although the latest U.S.-China trade talks were market-friendly, i.e., three days of negotiation seems to have narrowed the differences between the two parties, it is far too early to declare "all clear." The two nations have until March 1 to craft a deal; without one, the U.S. has threatened to boost tariffs on $200 billion in Chinese goods to 25% from 10%, a move that would severely set back global growth prospects.

One critical factor working in favor of a deal: The White House, in the face of struggling U.S. equities due in part to China trade fears, is increasingly amendable to a deal. It's slowly dawning on the White House that trade wars, the longer they go on, are costly. And the fight with China could be particularly costly to the U.S. considering the fact that China happens to be America's top creditor (China owns nearly $1.2 trillion in U.S. Treasuries), key export market for U.S. companies (China accounted for 8.4% of U.S. goods exports in 2017, double the level of Germany and France) and ranks as one of most profitable markets for Corporate America in the world (in 2017, U.S. foreign affiliates earned $13.4 billion in China, more than Germany and France combined according to Bureau of Economic Analysis).

The world's largest debtor nation, America, is dependent on foreign capital inflows, notably from China, one of the world's largest exporters of capital. That said, however, foreign investment flows from China to the U.S. have dried up over the past year, tumbling 84% to $4.8 billion in 2018 from $29 billion in 2017, while Chinese holdings of U.S. Treasuries have plateaued (see Exhibit 3). In addition, America's goal of staunching the technological rise of China seems like a pipedream. As Exhibit 4 highlights, China is already on its way to being a global technology giant, with a 10-fold increase in the number of U.S. patent grants over the decade. As the total number of issued U.S. technology patents declined in 2018, every country except China received fewer patents than the year prior.

Thought of The Week

Blueprint for a Turnaround

Chief Investment Office

Another round of turbulence struck financial markets during the fourth quarter of 2018, as economic data continued to signal a softening of global growth, along with a continuous removal of monetary stimulus and liquidity from the Fed. Against the backdrop of a U.S.-China trade war and political uncertainty in Europe, these factors contributed to a significant re-pricing of risk both in the U.S. and abroad.

Exhibit 3: Chinese Holdings of U.S. Treasuries.

Exhibit 4: China's Growing Number of U.S. Patents.

For both parties, the costs of the trade war are rising, which provides some hope of an imminent deal. That said, recall that at the beginning of 2018, the consensus was that Washington would push China hard on trade, accept some limited and symbolic wins, declare victory and move on. Reality was different.

The U.S. smashed a lot of china in China in 2018. Avoiding further damage will be key to global market returns in 2019.

By the end, the S&P 500 had fallen by 14% (its worst quarter in seven years), credit spreads had reached multi-year highs; investor sentiment was shaken; and some began to fear we could see a recession by the end of 2019. As the dust settles, it's important to reassess where we stand.

Exhibit 5 provides a useful template to illustrate the status of the key drivers of the market as we progress through 2019. Earnings growth of 5-6% remains the base case as strong consumer demand and solid capital spending continue to drive corporate revenues. A number of sentiment indicators have reached extreme bearish levels (a common contrarian buy signal), while valuations have become more attractive for longer-term investors. We feel a pause by the Fed is in the cards as it realizes that inflationary pressures are diminishing, and we remain optimistic on the chances for a short-term deal between the U.S. and China by March 1.

This would be risk-on for the markets, steepening the yield curve and leading to a softer dollar, which should help to boost beaten down international equities like emerging markets.

Exhibit 5: CIO Investor's Dashboard.

Less uncertainty on trade would improve visibility on corporate earnings, while improved sentiment should lead to more investors re-entering the market.

While it may take time to get clarity on these issues, to the extent that these "negative" dots in Exhibit 5 stabilize and move toward the right without the "positive" dots shifting too far to the left, we remain optimistic that equities should be able to establish a more sustainable upward trend.