The Necker cube is the name given to an optical illusion that was published in 1832 by Swiss crystallographer Louis Albert Necker. The cube is drawn in isometric perspective in a manner that makes the picture ambiguous; though only one drawing, it can be interpreted two different ways. Similarly, the era of quantitative easing (QE) blurred the lines between “investing,” or generating wealth over time with a buy-and-hold approach, and “trading,” or turning assets over frequently in the attempt to capture alpha. The powerful liquidity growth of recent years has flattered the price-return component of most asset classes, and simultaneously it has suppressed yields and spreads, which has muted the attractiveness of the income, or “carry” component, of total return. Thus, both approaches benefited from a sole focus on harvesting beta, with a marked de-emphasis on generating income. Both approaches were pursuing a single strategy, yet still widely perceived to be two different disciplines.
Monetary policy landscape
However, 2018 has introduced a new mix of global policies that have effectively ended this investment illusion. As a transition toward less market-friendly global policies deepens, we think the use of a broader historical lens engenders a renewed appreciation for the income component of total return, which over long-periods of time is incredibly valuable and potentially is grossly underestimated today.
The new macro environment is highly complex, which clouds visibility along multiple fronts. In the United States, the Federal Reserve’s own forecasts for future rate hikes are now heavily discounted by the markets, which suggests a widening cone of forward macro uncertainty.
In Europe, the European Central Bank’s early-year intention to begin policy “normalization” has been thwarted by an unexpected growth deceleration. China is endeavoring to thread the policy needle by proactively slowing heretofore rampant credit growth without creating a hard economic landing. All of this is now further confused by an escalating global trade war that risks being played out to a pernicious, protectionist, end game.
Untangling M.C. Escher-like Macro Complexity
To solve this puzzle, we analyze the component parts individually. First, we have a fairly sanguine outlook for the Fed’s prospective policy path. Current white-hot growth and sentiment indicators are already well known, and will likely face organic headwinds in the back half of the year and beyond. Specifically, solid late-cycle wage growth, overall rising SG&A expenses, and broadening capacity constraints are a rising threat to corporate profit margins rather than a nefarious inflationary catalyst. Systemic pricing power is being held in check by ubiquitous technological forces that we’ve discussed for years, such that these late-cycle margin pressures are likely to dampen growth and sentiment over coming quarters, which in turn alleviates pressure on the Fed to aggressively tighten.
Global trade tensions
Second, global economic growth is highly vulnerable to burgeoning global trade tensions with the U.S. Though the U.S. relies less on trade for domestic growth than most other nations do, overall U.S. trade volumes taken as a stand-alone economy would nevertheless rank as the world’s fourth largest, making ongoing robust U.S. trade activity a critical ingredient to healthy global growth. Moreover, virtually all of the nations who contribute the majority of non-U.S. global growth (especially in Asia) are heavily reliant on trade as a driver of economic vitality. So, near term trade policy uncertainly is increasingly encumbering real-economy psychology and threatens a more painful contraction in overall global activity if it intensifies further.
China’s economic growth deceleration
Third, China has experienced a notable deceleration in growth in 2018, as policy makers there aspire to reign in heretofore surging domestic credit growth. Indeed,
China M2 has grown by more than $3 trillion over the last year, to a staggering $27 trillion, and is now almost twice the size of U.S. M2. Yet, a point of saturation for Chinese borrowers is likely unfolding as credit multipliers have approached zero during the recent cycle, according to the International Monetary Fund. Thus, China must navigate a credit-driven economic deceleration without stoking capital flight. Clearly, further economic deceleration in China would quickly reverberate throughout the rest of Asia, Europe, and the entirety of the emerging market (EM) world, a result of entrenched trade corridors between these geographies.
In the face growing uncertainties, we’re increasingly convinced that while the Fed may be in play for a bit longer, the end of the tightening cycle is much closer than most generally believe. A dovish pivot by the Fed would facilitate the evolution toward a virtuous new equilibrium with observable cyclical momentum. Until then, we think it’s critically important to distinguish between investing and trading, as we’ve outlined above. For investors, highly efficient carry is now plentiful via short-duration, high quality, spread assets. For traders, tactical opportunities will abound from the certain volatility that lies ahead, as the current global policy frictions progress toward a more stable plateau.
Asset Allocation Implications
Regarding asset allocation, we’re now employing a two-pronged approach. For more traditional strategies, we favor defensiveness and carry, and we are finding plentiful expressions of this in U.S. rates (mostly the front-end, along with some moderate long-end exposure in deference to the powerful ongoing pension demand for duration), in high-quality spread sectors, and in U.S. dollar exposure. For absolute return-oriented strategies, we also identify sectors that possess large potential near-term price volatility, looking to assets that optimize a mix of convexity and liquidity, such as EM foreign exchange, U.S. equities, and idiosyncratic situations across the credit universe.