Season’s Greetings


Jefferson V. DeAngelis

Jefferson V. DeAngelis

Season’s Greetings

December 18, 2017

As 2017 ends, investors are fully engaged in a seasonal event as much a tradition as eggnog or caroling this time of year. It’s forecasting season. As part of this annual ritual, we take stock of what did or didn’t come to pass this last year and offer market expectations for the next twelve months. Those that have gone through this season more than once know that few forecasts will come to pass as the art of forecasting financial markets is fraught with hazards.

Humans have a nearly infinite capacity to imagine and a strong tendency to avoid risk. Forecasts, therefore, often tend to be extensions of recent trends, projecting the status quo. Conventional thinking often fails us by sticking with the status quo too long. History demonstrates time and again that the status quo is a questionable starting point, as future events rarely follow the pattern of the recent past.

Not surprisingly, conventional thinking, captured by the status quo, often leads to poor investment performance. The challenge for investment managers is to think outside the box. Yet, achieving some degree of accuracy does not mean wildly swinging for the fences. Case in point, when forecasting it is prudent to forecast rates or dates but not rates and dates. With time forecasts seem to become more accurate.

This past year was an example of forecasts underestimating the potential for returns. Most honest observers thought that the unthinkable Trump presidency would bring sub-par returns to Wall Street despite the Main Street prospects for health care repeal, tax reform and infrastructure spending. The rapid rise in interest rates that many predicted never materialized and inflation, which was a concern, remained subdued. Perhaps, most astonishing to pundits was the muted level of volatility. Given the shifting rhetoric in Washington, one might have expected more volatility. Certainly, no one would have predicted a 25% increase in stock prices without a 3% correction since Trump was elected.

Many forecasters failed to give enough credit to the central banks in legislating a bull market in risk assets. Liquidity has had a much larger impact on maintaining order than many, including us, would have thought possible. Ironically, the flood of liquidity has not created any noticeable imbalances. While it is true that credit creation appears stretched, it does not show signs of undue stress. Financial asset inflation has led to speculation in markets with little or no impact on production, wages and productivity. Stock buybacks and other forms of financial engineering have been a source of earnings growth without a meaningful top line impact.

Another miss was energy prices, which on the margin have been influential in the mean-reverting nature of GDP. Oil has aided central banks and legislatures in managing the economic cycle. The spot price of oil has acted in a countercyclical fashion with the appropriate lags. Falling oil prices are associated with demand destruction. In fact, periods of falling energy prices have been stimulative. Cheap gasoline at the pump acts more like a consumer tax cut. The opposite is also true. Attempts by OPEC members to maintain artificially high prices acts as a consumer tax increase. Oil is stronger going into 2018 and should push inflation expectations higher and growth potential lower.

However, the one constant missed by most forecasts has been persisting subpar economic growth. Since the financial crisis, projections have consistently overstated potential growth. Short-term strength has quickly faded. Likewise, periods of short- term weakness have been met with modest acceleration. Growth in the developed world tends at 2%, while expansions in emerging market countries have two or three times that potential. There appears to be a strange seasonality to it all. Unexpected strength in the second half of each year encourages economists to extrapolate good times into the future. The first half, on the other hand, tends to disappoint. While trying to avoid the trap of the status quo thinking, we believe economic growth in 2018 will repeat the disappointment.

In scanning over recently published forecasts, the limits of conventional thinking are arguably on display once again. A growing consensus beginning to form is that next year is now viewed as a continuation of 2017. Not surprisingly (at least not to regular readers), we have a slightly different view going of 2018.

Our view is informed in part by the intentions of central banks to withdraw unconventional monetary accommodation and raise interest rates. The Fed will reduce its balance sheet by approximately $420 billion and raise rates at least three times. The European Central Bank will purchase $500 billion fewer securities. The Japanese will move away from their policy of 0% 10-year rates. This will all put upward pressure on interest rates exposing credit problems and increase the risks of recession into 2019. The flattening yield curve is already indicating the tendency for the end of the cycle to be approaching.

Market pundits suggest that the good news for the markets are not baked into the record valuations of stocks. Meanwhile, the same analysts believe the tightening financial conditions are fully discounted. It is not possible to discount the withdrawal of liquidity from an unprecedented monetary experiment. We presume, like many, that the extraction from easy money, easy credit will not be painless.

Geopolitical risks will take a back seat to central bank liquidity in terms of determining investment performance. It is virtually impossible to discount the unknown unknowns or black swan risk. Nevertheless, given high valuation in combination with the withdrawal of liquidity the negative consequences of low probability events are higher. Valuation can be a shock absorber during periods of low valuation and an accelerant in times of excessive valuation.

Next year is likely to include a few surprises; the future by nature is uncertain. The surprises could be of a positive or negative nature given the state of the world. However, it’s notable that Brexit, Trump’s victory and even the threat of nuclear war in Korea proved to be mere setbacks for risk seeking investors. The wall of worry while steep was easily climbed. The asymmetry of risks in 2018 suggests to us that negative news will be more impactful than positive news given high valuations.

Stock prices will, at some point in this cycle, revert to more moderate returns. In effect, today’s valuations are borrowing something from future potential. Interest rates are a significant factor in valuation. A rise in inflation and interest rates at this phase of the economic cycle, while not a surprise will temper enthusiasm. Rates are headed higher in the short end of the curve as the Fed continues to remove monetary accommodation. The 10-year maturity treasury market is constrained by the fact that terminal short rates this cycle are unlikely to exceed 3%. Against that backdrop, long- maturity treasuries are anchored at current rates and have positive potential. As a result, we believe that the yield curve will continue to flatten.

In summary, in offering our forecast, we predict that 2018 is likely to see interest rates rise slightly and equity markets to experience more moderate appreciation. Financial conditions should tighten, and credit spreads should widen modestly. Central banks will gradually move to a more restrictive policy as inflation risks rise. The risks of a recession will increase over time as the sugar high from the fiscal stimulus of the U.S. tax cuts recedes.


©2017 Northwest Passage Capital Advisors LLC. All rights reserved.

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2018-01-29T21:40:11+00:00 By |