Oftentimes I write updates after conferences in order to process and make sense of the information I have just taken in. This is my attempt to make sense of SIC 2017, John Mauldin’s annual get-together.
The first thing I took from the conference blog was that unlike all of the last several years, there was no referring to the United States as the “cleanest dirty shirt” or “best house in a bad neighborhood”, or any other euphemism for the idea that although things weren’t going that well in the U.S., everyplace else was worse. Several speakers brought forth the notion that in turning insular (cancelling trade deals, banning immigrants, etc.) America was ceding the future to China. China, through its initiative to conduct more trade across the Eurasian land mass through its “One Belt One Road” construction projects, is replacing the United States as the global economic engine (meaning the most important nation to have trade relations with).
The second important idea many presenters shared was a sense of being in the “fat years” so to speak. That means central banks are going to support the current economic recovery with expansive monetary policy and in some cases outright asset purchases until it works no more. Therefore, expect to go a very long time until the next global recession (we have been sacrificing magnitude for length in our economic cycles since the 1980s). But oh God, many presenters stressed, the next true global recession will be bad, because there will be nothing left for central banks to fight it with. Furthermore, we will have to confront what will become obviously unserviceable sovereign debt and pension obligations at that point. “Demographics is destiny”, Mark Yusko said (and many agreed), meaning we can see the wall that we are going to crash into but it is too late to do anything about it. Before this cycle ends, however, Pippa Malmgren believes we may see a “melt-up” in stock prices. Perhaps we are seeing that now.
I had some concern that with the French election widely predicted to go to Macron in the days leading up to May 7th, the rise in European stock prices might be a “buy-the-rumor-sell-the-news” kind of thing. However, that has not proven to be the case. European stocks have continued to be strong performers, especially for dollar-based investors as the Euro has surged against the dollar. As a result, we are changing our domestic to international ratio in portfolios from 2.5 to 1 to 2 to 1. That means a 60-40 portfolio would move from 43% U.S./17% foreign to 40/20. It doesn’t make me feel great that in essence we are moving in the same direction as everybody else, but it is a situation where valuation, momentum, top-down fundamental analysis, and technical indicators all agree. There may be a need to consolidate recent gains (a correction of 2-5% could occur at any time given the approximately 15% gain this year), but it appears that the trend that favored the U.S. basically since the global credit crisis ended has finally begun to reverse.
Asian stocks have also been strong and I would not want to suggest Asia should be underweighted. There are near-term concerns with China as efforts to curb money supply (in order to rein in speculation) could give the stock market a bumpy ride. That said, China, India, and several other Asian nations are in a position to improve the quality of life for large swaths of their population, and in the West that has always coincided with strong financial performance. Latin America, on the other hand, should be underweighted. Though truly hopeful things are happening in Argentina, investable funds and ETFs are dominated by Brazil. That just isn’t going to go well in the near term.
Growth vs. Value
Growth as an investment style has dramatically outperformed value so far in 2017. See Chart 1. The predicted economic surge has not materialized, so investors have returned to stocks with predictable, non-cyclical growth. With declining economic growth expectations, interest rates have fallen. Two major implications from that: 1) financial services companies will earn less from lending, both in volume of loans and interest on those loans, so financial stocks may continue to under-perform, and 2) a dollar earned in the future is worth more, so we can pay higher P/E multiples for revenue growth-focused companies like Amazon. Another thing hurting the value side is the terrible performance of the energy sector year-to-date. Despite the OPEC agreement to maintain production limits for another nine months, it would appear that the world has all the oil and gas it expects to need.
Perhaps the most difficult thing to do as a market strategist is forecast interest rates. 2017 predictions were near unanimous in calling for higher rates. The only questions were how much and would the yield curve flatten or steepen. It is unclear why interest rates have fallen this year as economic growth is still solidly positive and the Federal Reserve is still on pace to raise rates this year. A very flat yield curve at very low interest rate levels would in theory be a worrisome sign from an economic standpoint. It suggests that while economic growth may be mediocre, that is about the best we can do. I thought short term rates would rise to reflect what we expected from the Fed over the next several months, and longer term rates would edge upward but not nearly as much. I cannot intellectually reconcile plunging long bond yields and soaring stock prices simultaneously. Stock prices are theoretically tied to corporate profits, which are positively correlated to economic activity. Falling bond yields (rising bond prices) are usually associated with a decline in inflation expectations brought about by lower economic activity. The only explanation that would make sense is that there just aren’t enough stocks and bonds in the world to meet investment demand. Is this really true? Have global central banks created so much credit in the banking system that the prices of all financial instruments are being forced higher? If so, how and when does this end? (In another words, how do they extricate themselves from this situation without creating a massive implosion of financial asset prices)?