Quarterly Investment Outlook: January 2018

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SUMMARY

  • The 2-10 year Treasury spread has flattened by more than 50% since yearend 2016 to approximately 60 basis points (bps).  Core personal consumption expenditure inflation (PCE) at 1.45% is struggling to trend higher and inflation expectations remain soft, despite wage inflation increasing 2.6% yoy.  The Fed could make a policy error by raising the Fed funds rate once in December (probability currently > 90%) and once more in March (probability currently > 60%), reinforcing market sentiment that inflation is unlikely to return to 2.0%.
  • We ultimately expect lower business taxes and expensing of capital equipment to survive a resolution of the House and Senate.  With the US economy operating at full employment, additional fiscal stimulus is likely to be inflationary to the extent that it is funded by increased deficit spending.  There may be some productivity benefits, but most businesses will use the increased cash flow to pay down debt or to increase shareholder returns via share buybacks and dividends.
  • In Germany, the 10-year bund yields a paltry 35 bps, which coupled with the strength of the economy and headline inflation at 1.80%, leaves financial conditions excessively easy.  Effectively, the real 10-year bund yields -145 bps.  The average spread between the US and German 10-year yield is historically 40 bps.  The current spread of 200 bps is unsustainable and should narrow in 2018, leaving the US dollar with further room to decline.
  • Our analysis of recession risk indicators (the rate of change in the Leading Indicator Series) continues to support the notion that the business cycle is unlikely to turn down over the next six months.  However, other measures of growth such as the ISM Manufacturing Index and the U.S. Economic Surprise Index are at elevated levels.  This is typically followed by a decrease, which may signal a slowdown in economic momentum.  This does not indicate a recession, but rather a decrease in the rate of growth over the next six months.
  • The US equity market is significantly overvalued.  The CAPE-10 P/E Ratio stands at twice its historic mean and median levels.  While valuation metrics are not good market-timing tools, they do suggest that real forward returns are likely to be nominal when viewed over a 10-year period. Market leverage is excessive and could exacerbate selling should prices drift significantly lower.
  • Preservation of capital is now paramount and value securities still trade at a significant discount to their intrinsic value and to the market. Our domestic equity holdings are geared towards late-cycle value plays, such as energy, financials, industrials, and miners.  Select foreign markets continue to offer relative-value and are better positioned to benefit from the global synchronized recovery.

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