Equities Are From Mars, Bonds From Venus
Full Commentary Link: Strategic Outlook: 1Q/2020 of Strategic Frontier Management
Key Topics: Outlook for 2020, Global TAA forecasts, Global Growth, Earnings Growth and Profit Margins, Secular Challenges of Emerging Markets, Inflation, Monetary Normalization, New Order in Global Trade, China, BREXIT, Outcome Equality vs. Equal Opportunity, Fading Geopolitical Risks, Household Net Worth and Retirement Savings, Equity Valuations, Sources of Uncertainty and Risk.
Men Are from Mars, Women Are from Venus is a bestselling book published by John Gray in 1992. The book discusses relationship problems between men and women, which he suggests are due to fundamental psychological differences between the sexes, as eponymized in men and women are from distinct planets. The book asserts differences between men and women can be understood in terms of distinct ways they respond to stress and stressful situations. Current perspectives from Mars vs. Venus highlight the differences of two seemingly different worlds in capital markets. Flip-flopping investor beliefs have coincided with increased equity volatility-of-volatility observed. Global markets responded in unexpected ways to changes in economic relationships over the last decade, although not surprising given continued market manipulation by central banks. Financial imbalances should normalize, including extended bond valuations, as central banks withdraw now unjustified crisis intervention. Monetary policy has failed to compensate for poor fiscal policy decisions and deteriorating demographics that limited global growth and investment.
At the dawn of a new decade and rising US potential growth, it is surprising denizens from two different worlds of Mars or Venus differ dramatically in their economic interpretation. Consider differences in stock vs bond market returns. The S&P 500 return of 31.5% in 2019 to 3231 far surpassed our noteworthy expected ~20% return with a 2950 year-end target. Meanwhile, Treasury 10-yr. yields plunged from 3.2% in October 2018 to below 1.5% in July, resulting in an inverted yield curve that awoke hibernating perma-bears to screech about recession expectations—does it matter bond yields declined more than short-term rates, rather than short-term rates rising faster than long-term? We have cautioned unusual forces do indeed matter from perspectives of Mars or Venus.
We have stuck with equities for a decade as high margins boosted earnings growth to keep valuations in check although the S&P 500 clocked a 507% return since troughing at 666 on 03/06/09. Still high US profit margins over 13% remain a paradox relative to lower US productivity, but measuring real growth is more difficult with low-to-zero priced services and apps. Venusian malcontents continue to suggest peak earnings, peak growth, and peak margins, thereby missing the 13.2% annualized return of the last decade—yet, valuations are still not stretched, although elevated and could limit future returns.
Investors are still cautious as strong equity returns drove valuations higher and earnings growth slowed below 2%. However, we would observe that steep declines in Energy (-38%) and Materials (-11%) dragged equity earnings lower from large-cap to small-cap. Moreover, strong earnings growth of 23% in 2018 bolstered US valuation heading into strong 2019 equity returns. US equity valuations are less compelling now, but 2020 earnings growth should accelerate to over 8%, enabling our 3450 S&P 500 target this year and 3650 next year.
Equity volatility-of-volatility provided contrarians with rewarding opportunities to buy-the-dips in 2018-2019, and suspect more of the same in 2020. Any correction of 7-10% should be an opportunity for tactically-inclined equity investors. However, a bond market correction is not. Divergent monetary, trade, and fiscal (tax & spending) policies reinforced the current Asynchronous Global Expansion, which reinforces cyclical economic divergences. Trade and investment forces should further bolster US potential growth, and yield greater international diversification across global equity, fixed income and currency markets with potential growth, inflation, earnings (margin, growth), and competitiveness divergences.
We expected US interest rates and bond yields to rise in 2019 with firming 2.3% inflation and 2.4% growth (no US recession)—instead, 10yr. Treasury yields fell from 2.7% to 1.9% and the Federal Reserve cut rates ¾%. If Treasury Bill yields should exceed CPI inflation by 1% and 10-year Treasury yields should exceed T-Bill yields by 1.5% based on historic averages, then if CPI inflation is 2.5%, Treasury yields can easily double to 4.5-5.0%. Investors got spooked by an inverted yield curve and negative global bond yields, as Europe and Japan flirted with recession. With high convexity, bond losses compound more quickly for each 1% rise in yield. This highlights a risk of extended duration and bond leverage increasingly adopted by pension funds adding risk parity strategies and LDI objectives. The flat yield curve must eventually rise and steepen, if only to 2004 levels.
Global central banks still are unnecessarily manipulating bond markets and keeping interest rates low for an extended period. This prolonged explicit moral hazard increased financial imbalances, yet economic variables don’t indicate any likelihood of a US recession. Instead, we believe global bond valuations remain extended and the best portfolio hedge is still cash or short-term bond funds. Some banks offered 2¼% yield on CDs and bank deposits last Spring, but cutting rates again lowered the hurdle rate for Bitcoin, gold, and alternative funds again, despite being volatile and costly for net return lagging inflation.
Receding geopolitical and economic uncertainty has helped restore investor, business, and household confidence—improved sentiment and employment boosted household formation driving up home ownership for a renaissance in housing demand, thus starts. We expect greater investment and strong employment with increased cash flow from income growth and earnings repatriation. The US model of reform for trade, fiscal, and regulatory policy reform should begin to spread globally to other nations hoping to maintain competitiveness. With new US trade deals, impeachment trial winding down, resilient US growth, US rate cuts, and BREXIT clarity after the UK election, our focus pivots to the US election and potential balance of power policy consequences. Carryover risks of war on terrorism (inc., Iran), slowing global growth, and fiscal deficits remain.
Source: Strategic Frontier Management
Investors seem concerned that an economic storm must be gathering, and appear fixated on equity risks, rather than overvalued bonds. We expect the US economy to remain resilient longer than consensus and don’t expect a recession in the foreseeable future with potential growth trending toward 2.7% and unemployment below 4%. Investor sentiment was undermined by Q4 weakness. US earnings growth should accelerate with waning geopolitical uncertainty that bolsters economic growth and inflation. We expect US economic growth will benefit from receding risks, while tax, regulatory and trade reform bolster net trade, employment, and investment. Internationally, we expect more of the same, resulting in US outperformance relative to Europe, Japan, and China, if not other struggling emerging market countries, but the UK could begin to diverge from the rest of Europe as clouds of uncertainty break up.
Our Global Tactical Asset Allocation return forecasts suggest global equities remain compelling and U.S. equity returns (S&P 500: 3450 by year-end) should significantly exceed bonds. We favor a tilt toward small-cap and modest bias toward value. Thus, we expect global equities will outperform global bonds by a wide margin, and a marginally stronger US dollar with a possible ¼% hike just after the election. Avoid safe havens (gold/commodities, cryptocurrencies, defensive investments--particularly rate sensitive exposures) and underweight global bonds. We favor a tilt toward small-cap and modest bias toward value.
Investors seem concerned that an economic storm must be gathering, and appear fixated on equity risks, rather than overvalued bonds.We expect the US economy to remain resilient longer than consensus and don’t expect a recession in the foreseeable future with potential growth trending toward 2.7% and unemployment below 4%. Investor sentiment was undermined by Q4 weakness. Real estate supply is in deficit, thus fears of a housing correction seem unfounded, although prices have been rising for a decade. This is more likely to draw in fence sitters, reflected in home ownership rates and increasing demand. Investors seeking opportunities to get an edge on the market routinely chase growth when the economy lags or earnings growth is low. Divergences in valuation are usually reliable sources of active outperformance, yet technology has continued to shine, even as valuations were stretched—so, value shrugged, as did small-cap stocks. We'd expect a value tilt to outperform growth long before equity investors reflect concern about S&P 500 valuation.
US earnings growth should accelerate from just over 0% to 8% or more with robust profit margin, as well as waning geopolitical uncertainty that bolsters economic growth and inflation. We expect US economic growth will benefit from receding risks, while tax, regulatory and trade reform bolster net trade, employment, and investment. Internationally, we expect more of the same, resulting in US outperformance relative to Europe, Japan, and China, but the UK could begin to diverge from the rest of Europe as clouds of uncertainty break up.
Global bond yields should rise, particularly as the US yield curve steepens, central bank holds begin to run-off again (refunding supply), and bond liquidity tightens. Importantly, we expect a negative real return for 10-year Treasuries over the next five years that could undermine balanced portfolio returns. Increasing debt imbalances and liquidity concerns could exacerbate correction of overvalued global bonds, as normalization continues. Credit spreads also may tend to normalize as Investors reduce portfolio duration and risk, although default rates shouldn’t change much, but increasing imbalances and liquidity concerns could exacerbate a correction. We expect global equities will outperform global bonds by a wide margin with a marginally stronger US dollar and a possible ¼% hike this year just after the US election.
Strategic Frontier Management, LLC is a California Registered Investment Advisor (RIA) providing Global Tactical and Strategic Asset Allocation solutions, as well as investment strategy consulting for asset owners and their investment advisors.
Disclaimer: This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third party sources deemed to be reliable. We make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication, and bear no liability for any loss arising from its use. All forward looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of this author, and future market movements may differ from expectations. Index performance or any index related data is provided for illustrative purposes only and is not indicative of the performance of any portfolio. Any performance shown herein is no guarantee of future results. Investment returns will fluctuate, and the value of holdings may be worth more or less than cost. © Strategic Frontier Management (www.StrategicCAPM.com) 2020. All rights reserved.