A Debate On The Markets: Thought Leaders Weigh In Views on current global economic and market conditions from a Fidelity Investments event in May 2017 Jurrien Timmer, director of Global Macro for Fidelity Investments, moderated a panel discussion at a Fidelity Investments event in May 2017. In a wide-ranging discussion, panelists offered valuable historic context, as well as their personal views on current economic and market conditions. The panel included: Mike Darda, Chief Economist & Market Strategist, MKM Partners Neil Howe, Demography Sector Head, Hedgeye Risk Management Julian Potenza, Fixed Income Research Analyst, Fidelity Investments What follows is an edited version of this panel discussion. My opinion is that business cycles don t just end accidently, they are killed by the Fed. If the Fed tightens enough to induce a recession, that s the end of the business cycle. Mike Darda, Chief Economist & Market Strategist, MKM Partners Jurrien Timmer (moderator): We ve been in a synchronized global upswing since February of 2016. For the first time since 2011, PMI numbers across the globe are moving up at the same time. After declining in 2014 and 2015, U.S. earnings are on the rise, with 13% year-over-year growth during the first quarter of 2017. We re in a robust earnings growth cycle, but the question is, how long will it last? 1 Mike Darda: We are now in the 8th year of the business cycle and the longest in U.S. history has been 10 years. My opinion is that business cycles don t just end accidently, they are killed by the Fed. If the Fed tightens enough to induce a recession, that s the end of the business cycle. 1 Fidelity s Leadership Series, Second Quarter 2017, Quarterly Market Update.
We re now coming out of a slowdown in profits, business investment, and recession. Why? My theory is that by moving to the sidelines for most of last year, the Fed allowed credit markets and inflation expectations to stabilize. That allowed the business cycle to pick up steam. Fed Governor, Lael Brainard was the key force behind that. Now that conditions have stabilized, the Fed has been able to raise rates and everything seems stable. That means they re doing it right.. Jurrien Timmer: Recently,there has been a very tight correlation between the ten-year Treasury yield and global economic momentum. When you look at that correlation, what does that tell you about the ten-year yield? Where we are in the bond market? What we could expect next? Julian Potenza: This gets into the preexisting global cyclical upswing that was under way before last November s election. An important factor that we haven t talked about yet is the stimulus package that China put through, which coincided with the Fed backing off their rate hiking plans earlier in 2016. Businesses are confident, and hopeful, and ready to unleash some activity on the back of whatever may come from this administration. But, the risk is that if you hold that spring coiled for too long, its energy starts to dissipate. Julian Potenza, Fixed Income Research Analyst, Fidelity Investments have no reason to think that s going to change. But it is something that the global economy is going to have to deal with at some point. Here in the U.S., we know regulatory policy is shifting with the new administration and we expect a generally more business friendly tone. However, there is also a lot of uncertainty overhanging the business sector. Tax reform is up in the air. Some of the proposals could produce dramatic changes to the way that interest, depreciation, and other things are treated. Businesses are going to want to see some clarity going forward. We have used the analogy of a coiled spring to describe the economy right now. Capacity is pretty tight. The unemployment rate is very low. Businesses are confident, and hopeful, and ready to unleash some activity on the back of whatever may come from this administration. But, the risk is that if you hold that spring coiled for too long, its energy starts to dissipate. You start to lose that snapback. I believe the bond market has gotten a little bit complacent based on what we can see from the Fed. But we do have capacity that s pretty tight, along with the potential for some sort of fiscal stimulus down the road. That leads me to believe that cyclically, there is a good argument for upward pressure on bond yields. However, on the longer-term secular horizon, I m still relatively downbeat in terms of my interest rate expectations. I don t really believe that we are entering a true secular bear market in fixed income. A lot of that is related to some of the longer-term concerns around China. Jurrien Timmer: Can you comment on the Fed s thinking as it relates to fiscal stimulus? I think those things were to some degree connected and played an important part in the surge of industrial activity that we have seen all around the globe. So where we go from here? In China, leverage continues to grow. Their private sector is probably as levered as it has ever been, which probably leaves the global economy as levered as it has ever been. In the near term, we Mike Darda: What most people think of when they hear fiscal stimulus is spending stimulus and Keynesian stimulus. But it s really about the supply side, the productivity that you get in the growth rate of the working age population. My friend, Scott Sumner, the leader of market monetarism, says, the fiscal multiplier thought of as Keynesian demand-side stimulus is nothing more 2
than a measure of Central Bank incompetence. This means that, if the Central Bank has an inflation target, they re going to keep nominal demand constrained in a way so that they don t overrun the target. If the Fed is more worried about overrunning its target than undershooting it, then they would respond to that by tightening policy more than would otherwise be the case. In fact, Janet Yellen and vice chair Fischer and others have come out recently and said, For every 100 basis point rise in the fiscal deficit, our models tell us that short rates should be 50 basis points higher. If you re going to do anything on the fiscal side to lift growth, it really needs to be focused on efficiency, and productivity, not just as a pump priming. We could end up with a situation where the Fed inverts the yield curve earlier than they otherwise would. On average, the yield curve inverts 14 months before a recession. That s why there s a tendency to say, It s different this time. Other indicators may look fine for a while and the stock market may continue to advance. Then we hear these theories about why it s different this time and the yield curve inversion is benign. That works until it doesn t work. Julian Potenza: Given the type of fiscal stimulus that it seems like we re more likely get, it feels a little bit more like demand stimulus and tax cuts rather than true productivity growth or tax reform. The Trump problem with Yellen could end up being that she s too hawkish rather than too dovish. Jurrien Timmer: When President Trump was elected, there were immediate comparisons with Ronald Reagan and Reaganomics. Can you speak to that? Neil Howe: I think the similarities between Reagan and Trump are sort of obvious. They both came in with a huge deregulatory agenda. They both promised at least to engage in a lot of tax cutting, a lot of what people would assume is going to be a lot of stimulus spending at a time when the Fed was going to be tightening. But then, you come to the differences. The first one is obviously the demographic situation. In 1981 when Reagan assumed office, the working age population in this country is growing at 1.6% per year. But Trump can expect over his entire term only about 0.2 percent per-year growth in the working age population. Reagan also came in when the both net and gross federal debt was at its all-time low as a share of GDP. You had this huge open fiscal room to run deficits. Non-financial debt as a share of GDP was generally stable for most of the post-war era, somewhere in the range of 140% to 150% of GDP. Today it s up over 200%. We are a much more levered economy today. When Reagan took office, our national savings rate was around 8%-9% of GDP. Now, it s down between around 5% or 6%. If we start running a big deficit, where are we going to get our savings from? It s going to push the dollar up. It s going to push real interest rates up. Julian Potenza: One other thing that s not as widely recognized is that both of the last two supply-side growth episodes in the early 1980s and the early 2000s coincided with massive credit booms in the private sector as well. Although there has been some deleveraging of household and financial balance sheets since the Great Recession, with retirement approaching for an aging society, it does not feel like an economy that s primed to go into another leveraging binge. Jurrien Timmer: When you add up productivity growth and labor force growth, together they form the potential for GDP growth. It seems to be sloping in the wrong direction. Are we stuck in this mode for the foreseeable future? Mike Darda: I hate to sound like a pessimist, but I am afraid we probably are. As disappointing as this recovery has been, the growth rates that we have enjoyed over the last six years or so have actually been above the growth rate of potential. That s why unemployment and underemployment are falling. Once we return to normal economic conditions and you re not be below the level of potential anymore, your growth path is totally dictated by productivity 3
and labor force growth. And that is slow and slow. Over the last five years, productivity growth is running just a touch over half a point per annum. Whatever you would like to call it, growth is going to be slower than what we have been accustomed to in past business cycles. Mike Darda, Chief Economist & Market Strategist, MKM Partners The Fed s estimates have growth potential at just under 2%, the same as the CBO. That might end up proving to be optimistic. We will need to see a fairly significant pickup in productivity to actually hit those numbers. Call it the new normal or slow growth, debt, and demographics. Whatever you would like to call it, growth is going to be slower than what we have been accustomed to in past business cycles. Jurrien Timmer: Where do you currently see opportunities among equities, bonds, cash, commodities, and alternatives? Mike Darda: Obviously, diversification is important. For the bond component of a portfolio, in my opinion, probably the most attractive area out there would be the high yield municipal bond sector. It s very difficult to compete with those yields, especially for investors are in the highest tax brackets. I would also suggest emerging markets exposure. But my focus there would be on the commodity importing emerging markets. They are a little more insulated in the event that the dollar starts rallying or China ends up slowing again. Julian Potenza: In terms of the bond market, I think there are some cyclical risks to bonds, meaning some risk of higher yields in the nearterm. The market is a little complacent in terms of its expectations for the pace of Fed hikes. I think investors should reflect that in their asset allocation. But that doesn t mean you should abandon fixed income completely. Rather, investors should consider keeping the portion of their fixed income portfolio that is currently earmarked for liquidity relatively short, in terms of duration. That said, they also could hold a smaller portion of the portfolio in long bonds, which provide welcome diversification benefits in an environment of high valuations across asset classes. And to bring it one step further, a part of that longer duration allocation could be held in TIPS to help protect against inflation risk, which are rising due to a tight labor market and a global political bakcdrop that has shown some signs of turning against globalization and towards protectionism. Finally, in terms of credit, while I don t see any imminent turn in the credit cycle, spreads are fairly tight and therefore over the next couple of years investors may want to reduce risk steadily and harvest gains in the credit section of their portfolios. I favor investments in other parts of the world that have much better valuations, such as India and Southeast Asia. These regions have more growth potential. Neil Howe, Demography Sector Head, Hedgeye Risk Management Neil Howe: I think the U.S. equity markets in general are overvalued and my overall bias is to shade away from them. I thinks TIPS are a good investment, as I expect real yields to decline. I favor investments in other parts of world that have much better valuations, such as India and Southeast Asia. These regions have more growth potential. They are demographically pretty well situated now and their productivity growth rates are higher. 4
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