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Long/Short Investments in L/S Equity: Valuation and Ideas,

Economy And Market Look Good Through August 2018

The economic expansion and bull market has now gone past 8-1/2 years in duration, and it appears as if it will continue through at least August 2018 according to projections.

The US Federal Reserve’s desire to increase interest rates and allow maturing assets to mature without reinvestment signals that some liquidity will be slowly drained from the economy. It won’t be much at first but accelerate gradually. Meanwhile, Japan and the EU are still on zero-rate, QE policies, which will support global asset prices.

The ECB recently announced a bigger cut (from €60 billion to €30 billion per month instead of from €60 billion to €40 billion), but larger extension, of its bond-buying program into 2019.

(Source: Barclays)

Mathematically it shouldn’t make a big difference. However, it does change the signaling involved in future ECB policy. Now that the program has been extended, investors can take note that an ECB rate hike before 2019 is effectively off the table, as the bank would halt its bond-buying program entirely before it would begin to manipulate rates.

With respect to the US, tightening Fed policy through rate increases and balance sheet run-off increases risks. If tax reform gets done in the US and thereby becomes fully priced into the market – bullish for stocks, bearish for bonds (except for many junk bonds, which will see their risks reduced) – both the monetary and fiscal policy tailwinds will no longer be available to investors in 2018 as they were in 2017. Nonetheless, any form of policy takes effect in the economy with a lag to both growth and inflation.

What’s a recession caused by?

When the growth in an economy’s spending exceeds that of its output, this generally leads to inflation by the simple fact that demand exceeds quantity supplied. This leads central banks to raise interest rates to keep inflation manageable – enough to incentivize consumers to spend but not too high that it reduces consumer confidence.

When the central bank tightens monetary policy, it slows the rate of debt growth in the economy, which leads to a fall in spending and a consequent economic contraction. Recessions end when the central bank begins to ease monetary policy, typically by pushing nominal interest rates below the nominal growth rate such that the economy can grow faster than debt can compound.

The spread between the short-term rates and nominal GDP growth is generally kept at around 100-200 bps. In the US, it has hovered at around 150-175 bps historically using mean and median figures, though it’s been larger during the current business cycle.

(Source: St. Louis Federal Reserve)

When rates are lowered heading into the decline of a business cycle, this reduces debt servicing costs, makes debt cheaper to help facilitate spending, and will also reflate financial assets by lowering the discount rate at which future cash flows are valued. More valuable financial assets create greater wealth among individuals, which ideally funnels down into greater consumer spending.

Where are we currently?

In the US, we are proceeding into a period somewhere between the mid- and late-stage of the cycle. Inflationary forces are low, which generally bodes well for the economy and risk assets. This means that the Fed is likely to remain fairly accommodative as it currently is – a 1.00% lower-bound rate and a $4 trillion-plus balance sheet. The Fed will raise rates in December, bringing the lower-bound to 1.25% and a 1.38% effective rate.

So long as low inflation remains, the longer this current economic cycle can likely persist as it limits the ability for the Fed to tighten.

To look at the future trajectory of the US economy I look at bank debit turnover – i.e., a proxy for transactions velocity in the economy – and form a distributed lag model to project out the next 10-12 months. If credit creation/spending look to be on a positive trajectory over this time, the economy is probably fine.

I use two separate but similar models and plot out the US stock market trajectory against them, which is an imperfect substitute for nominal GDP. The orange line – representing year-over-year stock market performance as represented by the Wilshire 5000 index – is expected to roughly follow the blue line (nominal US GDP growth proxy) in the future and has generally stuck to this pattern in the past.

(click to enlarge)



Note that the blue line is a projection of future economic activity in the US rather than an explicit prediction of what the US stock market will do. The stock market is a part of the economy, but not the economy itself. Accordingly, it’s a bit of an apples-to-oranges comparison, but there should still nonetheless be a reasonable correlation.

Based on this, it predicts that the stock market will not see the year-over-year returns of recent history following the financial crisis, but should hold relatively stable through at least August 2018 at these lower growth trajectories.

With central bank “puts” still in effect in Japan and Europe (0% interest rates and QE), this should help asset prices appreciate going forward, despite the Fed beginning to tighten into a highly indebted global economy.

Non-financial debt at the corporate level as a percentage of GDP stands at 72.2%. It reached its all-time peak of 73.8% during Q1 2009.

(Source: St. Louis Federal Reserve)

Conclusion

With high debt, aging demographics, and productive resource underutilization in the developed world, low inflation is a structural issue rather than a cyclical one.

Inflation will go up some in the short-term with the growth being generated toward the latter stages of this cycle. However, it won’t be much and central banks will have limited ability to tighten their monetary regimes. This keeps discount rates low and allows assets to trade off higher earnings multiples.

If interest rates stay where there are currently, I predict forward long-run nominal stock returns to be a little bit under 7% annually.

All of the main US equity indices and ETF instruments -- SPY, SPX, DIA, DJIA, QQQ, NDX, IWM, RUT -- are quite likely to be higher by the end of August 2018. 

As for bonds, it would depend on the type. Those that trade more on credit-quality considerations, such as high-yield (e.g., HYG, JNK) are likely to follow stocks, but it will depend on inflation. If inflation runs higher in the near-term, ETFs like IEF, TLT, AGG, BND, LQD may dip slightly given their dependence on rates less so than credit. Nonetheless, I am bearish on inflation long-term.

Will continue to update this monthly.