Three Key Thoughts:

• Fed in a quandary with conditions tighter before rate hike

• Risk of recession rises as weaker growth leaves less cushion

• Middle East uncertainty grows

In 2014, the US Federal Reserve wound down its “quantitative easing” program (buying of US Treasury and agency mortgage bonds) with little apparent impact on economic growth, bond rates or stock prices. Some of the volatility we experienced this year is likely a lagged effect from the termination of that program. More important, we believe, is that investors have been obsessed with the first prospective Fed rate hikes since 2007.

In being so obsessed, the markets have largely discounted in the effects of one or even two rate increases. The value of the dollar is much higher against virtually all other currencies, credit spreads have widened to levels not seen since 2008, stocks have wobbled, volatility has increased and the narrative is now about whether the global economy is too weak.

Having achieved these tighter financial conditions with the mere threat of an initial rate rise, we suspect the Fed now finds itself in a quandary: should they get it over with (how much worse could it be…) or do they risk making conditions even tighter, maybe causing a pullback in a weak growth environment. We have long believed that the Fed will keep rates lower for longer than most investors (and the Fed itself) expects. That said, markets would have been well-served by the Fed getting an initial hike out of the way, rather than leaving the prospect out there for investors to worry about.

Bottom line, however, we view this debate as a near term financial market obsession rather than something likely to have a major impact on the growth rate of the US economy. As we have said repeatedly, we expect the US economy to grow at around a 2% rate for the next several years. At that slow rate, a recession is always a risk because of the small margin available to absorb any shocks. Conversely, we think an overheating economy with rapidly rising inflation is a highly unlikely scenario.

This rising risk of recession is reflected in the growing spreads on investment grade and high yield debt. Earlier this year, spreads on debt of energy issuers blew out to very wide levels, as investors expect a wave of defaults in that space beginning in the next several months. However, that uncertainty has spread more broadly to corporate issuers who have used low rates to increase the leverage on their balance sheets at low cost.

The geopolitics of oil is certainly complicating the picture as well. On a pure supply and demand basis, we are oversupplied in the short term, which will keep prices subdued. And, with the Iran nuclear deal moving forward, the supply picture will likely get worse before demand begins to catch up. On the flip side, unrest is bubbling up throughout the Middle East once again and no one can predict how the conflicts might progress.

With Russia having entered the Syrian civil war more forcefully, the risk of wider conflict in the region is much higher. We aren't surprised by their moves as they were widely telegraphed by President Putin. However, Russia is the one country with the power, economic incentive and guts to raise the price of oil by creating unrest. Under the current administrations, the US and its allies have prioritized diplomacy over military action but it is unclear to us if this reduces risks or creates a vacuum into which bad actors like ISIS can grow their power.

Regardless, we view the uncertainty in that part of the world as a rising risk to the global economy, more so than other popular concerns like the slowdown in China. While we are talking about risks, there are two in Europe that deserve mention. First is the growing tide of refugees streaming into southern and central Europe. We expect that this will continue to grow for some time, taxing both the resources and political agenda of an already weak Eurozone. Second, and perhaps more troubling, is the Volkswagen emissions fiasco. This situation has the makings of Europe’s Enron/Worldcom moment and we could see it harming Germany’s export- driven economy and spawning a new wave of regulation.

China continues along on its bumpy descent toward a more sustainable growth rate, driven by a service-oriented economy. The authorities badly handled the A share market run up (cheering too loudly) and subsequent crash (several ham-handed interventions intended to stop the selling), destroying some of their reformist credibility. They are learning as they go, however, and market reforms in the currency, bond and equity markets will continue at a slower pace.

Prime Minister Abe of Japan announced Abenomics 2.0 to little fanfare, as his new “arrows” added little of substance to the original three arrows. Much reform has been accomplished in the corporate sector and a greater emphasis on reforming work rules and growing the work force will continue to help the Japanese economy increase its potential growth rate. The recently agreed Trans-Pacific Partnership should also help boost Japan’s export sector. However, big challenges remain, including the inability to grow the work force over the long term without immigration, and recent data show mixed results for Abe’s aggressive agenda.

With risks rising outside the US, we cut back our international stock exposure somewhat in favor of an increase in hedge fund strategies. So we are now overweight in a broad group of hedged strategies, underweight in US small cap and underweight in fixed income. We have maintained a neutral approach on US large cap as we believe this area of the market will continue to serve as a safe haven for equity investors.