To the relief of many, the US election should be over by this time next week. Not only will the US have a new President, but we will know who controls Congress and the Senate. Clearly markets have been ruffled by the Trump resurgence post the FBI investigation news from a week or so ago. As with the Brexit experience, life will settle down whoever wins and we now need to think about what the next few months will bring. For what it’s worth, if Trump does win, we think equity markets drop and we will look to buy into that weakness to benefit from a post trauma bounce (not unlike Brexit). If Clinton wins, equities should rally modestly but we look to sell that rally as HRC represents the status quo, of which we are bearish. We see less sensitivity to either outcome in the FX and bond markets.

So, trying to look past the election, we see a relatively short cyclical pick-up in growth and inflation. This is partly down to a low base effect from the oil price which will help at least through February 2017. Yet, reading some of the recent business survey commentaries, there is a feeling of some actual improvement in general conditions as well. With both growth and inflation nudging upwards, and the Fed telling us that the case for a rate hike has strengthened since September, we fully expect a second rate rise in December assuming the equity market behaves itself (more on that later!).
Chart 1 – The Fed Funds Rate and the Shadow rate over the last few cycles

This all has a feel of a classic late cycle phase, where the central bank continues to tighten policy as growth and inflation nudges higher. The current recovery is 89 month old now, the third longest in the post WWII period, and according to a policy adjusted model, the Fed has been tightening quite a lot in the last couple of years. Chart 1 above shows both the Fed Funds rates and a “shadow” rate developed to measure the policy rate adjusted for the unorthodox policies employed since the financial crisis.

What’s interesting looking at Fed policy through this lens is that policy has already been tightened by about 3% which is comparable to the 4% tightening periods seen prior to the last three recessions. As can also be seen by looking at real GDP, growth has shifted into a lower gear post the financial crisis, and it is very possible that the tightening implied by the shadow rate, along with a modest increase the Fed Funds rate, may be enough to tip the economy into recession next year.

We have a roadmap in mind which sees growth and inflation move higher over the next 3 to 6 months. This will not only encourage the Fed to raise rates, but should also lift bond yields, a theme we have been talking about for some time now.

Now here is where we can visualise two outcomes. We have explained before how we think fixed income investors have stretched themselves in the search for yield, through a combination of duration, credit exposure and even leverage. There is a distinct possibility that a continuing bond sell off will become disorderly which could impact the financial markets generally and also the real economy. There is also a possibility of what we would call an elegant reflation, whereby yields rise ever so gently whilst risk assets celebrate better growth and inflation.

Whereas the disorderly sell off scenario is immediately bearish of both financial markets and the economy (and would surely keep the Fed on the sidelines), the elegant reflation buys a couple of quarters of time for markets to perform before the larger maturity of the business cycle kicks in, and recession risks rise anew.

There does remain an elephant in the room and that is the equity market that remains grossly overvalued. In chart 2 below, we show the performance of the equity market and corporate profits (as measured in the national accounts) alongside the total number of employed persons. Historically, and as should be expected, profits and stock prices are quite closely correlated, and employment follows with a bit of a lag. Our overriding concern remains that an equity bear market will simply encourage CEOs to cut jobs and capex which would undoubtedly push the economy into recession.
Chart 2 – The stock market with corporate profits and total employment

If the current deterioration in the equity market gathers strength, then our cyclical uplift thesis will be obsolete and there will certainly not be any elegant reflation. When we have such diverging market outcomes as realistic possibilities, we need to maintain a very flexible approach to markets, and of course we cannot ignore the possibility that global central banks will fight any market weakness with even more stimulus.

If it feels like we are leaving a lot of loose ends this week. That is because the short term outlook is so uncertain on many fronts. We remain comfortable with the fact that the likely returns over the long term will be low single digits for most mainstream assets, and investors will be both disappointed and vulnerable to periods of intense volatility. At a minimum, our flexible approach allows us to sidestep these periods and hopefully benefit from rising volatility and a degree of directionality that has been sorely missing in recent months.

 

Stewart Richardson
Chief Investment Officer