This quarter, we asked Gratus Capital Director of Investments Todd Jones, MBA, CAIA, to weigh in on the current financial environment and critical market trends.
Here’s what Todd is talking about this quarter.
Are there any specific Q1 market trends you’re monitoring?
The first of the year is shaping up to be positive as earnings are still very strong. In fact, for the first time in the past five years, U.S. and international companies are reporting increasing earnings, strengthening the equity market.
However, at Gratus we continue to believe that it’s likely the market will experience a pullback during the first half of the year. The equity markets have been growing for so long without a significant correction that it’s likely to happen at any time. Click here to read Todd’s February Market Update
It’s a different story for the fixed-income markets. Here, we see an elevated level of risk as opposed to years past because starting yields are so low. In addition, the degree to which the Fed can manage their balance sheet reduction is critical to a continuation of upward movement for risk asset management. Because there is a likelihood of fixed-income assets not being priced accurately, they have the potential to introduce a lot of risk.
If the interest rate program that the Fed has been pursuing leads to a disorderly sell-off in the bond market, we could see some severe downside movement in risk markets, such as equities and high-yield bonds.
Commodities and Emerging Markets
For other 2018 trends, we’re starting to take a closer look at asset classes we haven’t considered in a while, specifically commodities and emerging markets. The conditions are much more favorable than they have been in several years.
Emerging markets have experienced considerable structural changes in corporate governance. Brazil’s crackdown on government corruption and China’s tightening of non-bank lending and increased control of state-owned enterprises are just a few examples. These structural government reforms are key factors in whether Gratus is willing to commit capital to this asset class.
However, recently, commodities have become more attractive, because they’re trading at all-time lows relative to equities. Back in 2011, Gratus sold out of these positions. Today, we’re taking a hard look at them.
What should investors be concerned about regarding the Fed and inflation?
The key question that needs to be answered is, why hasn’t there been any inflation in the economy?
Generally speaking, inflation is toxic for equity and fixed-income assets. However, it’s important to keep the following in mind: If the Fed continues with its proposed interest rate program, rates are scheduled to increase three to four times in 2018. If the Fed proceeds with this plan and inflation doesn’t appear, the Fed runs the risk of creating an inverted yield curve, meaning short-term interest rates are higher than long-term interest rates.
Gratus believes the Fed will not proceed with their interest rate program in 2018, because economic growth won’t substantiate the current proposal. This means long-term interest rates will remain level. Although stable interest rates are good for valuation, it’s problematic long term for the economy.
Going back the past 60 years, every time there has been an inverted yield curve,
a recession has followed.
If we can’t generate the inflation in the economy that the Fed hopes for, we run into the problem of another recession hitting while low inflation occurs. If this happens, the Fed will have limited tools to combat the problem.
Case in Point
The Bank of Japan has fought deflationary forces for more than 30 years and has essentially made no economic progress.
However, there is one key caveat: If the just passed tax reform act combined with deregulation stirred real economic growth above 4%, we would likely change our minds on the forward path for interest rate increases.
What is the real impact of the recent and anticipated tax regulation changes?
The recent tax law changes are the biggest sweeping changes to the tax code since the last comprehensive tax reform in 1986.
Tax rates are coming down for U.S. companies, and incentives to invest in the U.S. are much higher than they were a year ago. Currently, the United States is a destination for domestic and international capital inflow.
Long-Term Warning Signs
We still see some warning signs in the economy.
First, the act wasn’t paid for. These tax cuts are being funded by increasing the budget deficit, which is a deflationary action.
Second, the primary beneficiaries are typically wealthier individuals. Getting people to back this act could be challenging if it is seen as self-serving.
Third, the tax cut is creating an incentive for companies to bring dollars back to the United States. This isn’t a bad thing BUT has the potential of strengthening the U.S. dollar as a currency versus other currencies, and as a by-product, would increase risk in the financial system. When the dollar goes up, other currencies, as a by-product, would come down relative to it. If the dollar goes up against all other currencies, it makes international trade potentially more expensive.
Overall, because the act isn’t paid for, Gratus believes that any economic growth generated by this tax reform act has the potential to be offset to some degree by deflationary forces of the debt that was created to generate growth. Many investors are overlooking the cost of the act.
Would you share some insights regarding Bitcoin and Blockchain?
Blockchain, the technology behind Bitcoin, is an important technology. It has the potential to transform how the financial industry processes payments and keeps records.
However, Bitcoin is still a highly speculative asset. Therefore, any investor contemplating a Bitcoin investment should be prepared for extreme outcomes, e.g., 20X growth or zero. In addition, it’s important to recognize that Bitcoin has not been in existence long enough to have survived a severe financial crisis, such as the ones experienced in 2000 and 2008. We have no history for how Bitcoin will perform in such extreme depressed markets.
Currently, Gratus is not including Bitcoin in our client portfolios. However, Bitcoin as an asset class has the potential to be a very meaningful diversifier due to its unique attributes. Still, we encourage investors involved with Bitcoin to be modest with their investments relative to the percentage of an individual’s net worth and be prepared for extreme outcomes in either direction.
Is there a key consideration investors should contemplate in Q1?
With markets at all-time highs, it’s a good time to consider risk management in a portfolio.
In the near future, Gratus will rebalance portfolios back to target weights. Specifically, we’ll be selling equities and buying fixed-income assets. We’ll also raise cash levels for clients with foreseeable withdrawals. Simultaneously, we’ll continue to review assets and other financial strategies that don’t highly correlate to equities, such as commodities.
Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of October 2017 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.