Three Key Thoughts:
- Low Expectations for DC
- Fed Scorecard: Three Pluses
- International Markets Optimism
Stock markets around the world continued their rallies in the third quarter. The US was no exception, with major averages closing the quarter at record highs. Increasingly, investors are recognizing that better economic and earnings growth prospects are breaking out broadly. Correspondingly, the US dollar has weakened, enhancing the returns on non-dollar-denominated financial assets and improving the overseas revenues of US companies.
The bond market’s boring streak continued through the third quarter. Despite some intra-quarter volatility in longer term rates, spreads and rates ended the quarter pretty close to where they started. Credit spreads remain relatively tight, though not at record levels, reflecting a still-positive economic outlook.
It is tempting to let the state of US politics color our investing views but it is important to keep a long term perspective. For the most part, we believe the current dysfunction in Washington is just a continuation of the sharp divide we have seen for the last decade. The issues and debates have morphed – and seemingly change at the speed of Twitter – but the net result is largely the same: very little change on important policy matters and no effort to address long term fiscal problems.
This state of affairs informs our base view that nothing major will come out of Congress on Obamacare repeal/replace/repair (a zombie issue at this point), income tax changes and infrastructure programs. At this writing, tax “reform” is foremost on the Washington agenda. However, absent any savings from changes to Obamacare, the scoring of a “lower rates, fewer deductions” strategy will make it extremely difficult for Congress to enact as part of a budget reconciliation process. As a reminder, budget reconciliation only requires a simple majority to pass BUT the changes must be revenue neutral over the budget window of 10 years. Because bipartisan solutions are just not in the Washington playbook anymore, we expect a lot of discussion but very little action. Bottom line, we believe the only help the economy will get from Washington for the next few years will be a reduced focus on regulation, which can be done administratively.
Meanwhile, the moves by the Federal Reserve to gradually reduce its support for the economy have been met with guarded optimism. The Fed has raised the Federal funds rate very slowly and cumulatively we have now seen four quarter point increases in two years. And we could see a similar number over the next eighteen months, if things play out as the Fed expects. In addition, the Fed intends to stick to its plan to reduce its bond holdings by not reinvesting all of the proceeds of bond maturities each month, starting this month.
So long as the Fed’s three key boxes – reasonable economic growth, strong employment and inflation near target – remain checked, we believe they will continue to raise short term rates slowly and reduce their balance sheet deliberately. The bond market doesn’t seem as convinced as the Fed right now though. Longer term rates have stayed low, perhaps a sign that investors are concerned the Fed will tighten too much, bringing inflation and growth down. Complicating the picture is that, even at current low levels, US Treasury bond yields look attractive by comparison to rates on comparable European and Japanese debt. We aren’t sure how this will be resolved but we remain cautious on fixed income investments, with the view that the primary risk is rising rates and falling bond prices.
Finally, non US stocks have been a bright spot for investors this year, with developed market equities handily outpacing their US counterparts. Bigger gains were found in emerging markets, which have nearly doubled the returns of US stocks. Part of this story is currency – weakness in the value of the dollar has played a significant role in developed markets’ excess returns. But more important, we believe, is that these markets have found what they were missing previously: better sentiment. The better growth, better earnings and reasonable valuations pieces of the puzzle had been evident for a little while. Now that sentiment has been added to the mix, we could see good relative returns for some time. That said, some markets may have already gone too far in the short term.
In client portfolios, we modestly increased our already substantial weight in international stocks, funded by a small reduction in the weight assigned to US stocks. We also made several shifts in hedged strategies to focus on managers and strategies we believe can deliver attractive, but lower risk, return opportunities. As noted above, we remain underweight fixed income as we expect returns will be low while risk remains high. We are continuing to evaluate the role of fixed income in portfolios with very long term time horizons.
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