Three Key Thoughts:

1. Is the US Economy Doing Too Well?

2. Federal Reserve is Still on Track

3. International Markets Trip on Trade Policy and Dollar

Is the US Economy Doing Too Well?

The US economy is running on all cylinders, growing far above its long term expected rate. Much of this extra growth can be attributed to the large corporate tax cuts that were put into place at the beginning of the year. So far, the US stock market has been tightly focused on these benefits, driving prices to all time highs.

An economy’s growth potential is pretty easy to define. It is simply the sum of the growth rate of the labor force and the rate of productivity growth of that labor force. Labor force growth is relatively predictable because it is driven mostly by demographics and, to a lesser extent, by immigration. Productivity is harder to measure and even harder to predict. But, looking back at history, it is hard to get sustained productivity growth over 1.5%.

For the US economy, this leads us to think that our long term growth potential is likely 1.5-2.0%. This is comprised of 0.5% of labor force growth and productivity growth of 1-1.5%. So the growth we are now seeing, well in excess of 3%, is far above potential. At some point – we suspect in 2019 -- the short term effects of the tax cuts will wear off. And the impact of higher interest rates will begin to take hold. Both of these factors will cause our growth to slow. The questions will become how much will we slow and when?

In a typical business cycle, strong employment markets lead to rising wages, which lead to inflation and higher interest rates. Eventually those higher rates choke off growth, leading to a recession. But this has been anything but a typical business cycle. The real estate debt bubble that burst in 2008 gave way to a long period of very slow growth and a weak employment picture. Only very recently – nearly nine years after the recovery started -- have we seen signs that low unemployment is driving up wages and inflation.

Bottom line, we view the current rate of US growth as unsustainable and, increasingly, the focus will be on the whether the Federal Reserve can engineer a slow down without a recession. We believe this so-called “soft landing” will start to be a concern in 2019.

Federal Reserve is Still on Track

Cautious optimism well-describes the Federal Reserve at this juncture. The Fed continues on its gradual tightening path, raising short term interest rates by another one-fourth of a percent and reducing its bond holdings. We, like most investors, expect the Fed to continue raising short term rates quarterly, as they have long telegraphed, so long as employment is strong, the economy is sound and inflation is around their 2% goal.

Combined with higher readings on economic growth and wage inflation, rates on longer term US Treasuries ticked up a bit in September. Rather suddenly, investors have become concerned that longer term interest rates might jump up quickly as inflation pressures are building. The actual rate increases so far are modest but enough to get stock markets’ attention. After such a long positive run, it would not be unusual to see a significant, but short term, correction in US stock prices.

We would become far more concerned if we were to see rates on lower rated (“junk”) bonds jump up quickly, while Treasury rates stayed stable or fell. In our opinion, this so-called “spread widening” could be a more definitive indicator of an upcoming recession. For now, these spreads remain very tight, reflecting the fact that investors believe the credit problems of a recession are well off into the future.

International Markets Trip on Trade Policy and Dollar Strength

In contrast to the US market, international equity markets have stumbled as investors have been concerned about the impact of a stronger dollar, higher oil prices and weaker overseas growth. We had thought, incorrectly, that the positive sentiment shift toward international markets in 2017 would continue for some time as the fundamental economic stories were still quite good. Instead, this sentiment sharply reversed as a couple of emerging markets (notably Turkey and Argentina) faced currency crises and investors became concerned about contagion risks.

Despite the isolated nature of those countries’ problems, broader concerns came to the fore as the Trump administration has embarked on a series of trade forays, the outcome of which seems far from certain. A renegotiation of NAFTA with Canada and Mexico, new trade agreements with Europe, the UK, Japan and South Korea, maybe a reconsideration of the Trans-Pacific Partnership and, most importantly, a complete redo of our trading relationships with China, are all on the agenda. While all of the efforts are cast in terms of “getting a better deal for the US,” it is not clear what we really are hoping to achieve.

The USMCA (US, Mexico, Canada Agreement) that was announced on October 1 may provide a template. This NAFTA replacement has lots of details to be reviewed and analyzed. Initial reaction is that the agreement has been modernized from an information technology perspective, some domestic content and wage restriction provisions have been added and the Canadian dairy market modestly opened. In sum, it doesn’t seem like a lot has changed. Perhaps the best that can be said is that draconian tariffs were avoided and the noise around these negotiations will now stop.

Maybe we are seeing the faint outline of a strategy forming: put in place new deals with all of our major partners except China, getting them lined up to provide unified pressure on China. We don’t know if this is actually administration strategy but it does seem clear that a near term deal with China is unlikely. This has important implications for any US business depending on China imports or exports.

Investment Approach

Our long term belief in the growth opportunities outside the US continues to be put to the test as international market returns were negative, against a strongly positive quarter for US stocks. We have taken some tax losses on certain emerging market positions and are in the process of deciding if, how and when to re-establish those investments. At some point, the long period of underperformance by international stocks will end – we just don’t know when.

We have held onto US stock positions as the US economy and corporate earnings continue to grow. However, we recognize that the US is likely in the latter stages of this cycle so some caution is warranted. Finally, we remain underweight in fixed income because that strong growth will likely cause rates to bleed higher, hurting bond prices.