Suddenly, it seemed, the global economy lost much of its punch. The tailwind of synchronized growth died under a layer of European ennui and the collapse of emerging markets; China throttled back on growth, first to deflate asset bubbles and most recently as a weapon in trade skirmishing with the US; Japan continued to struggle with inert consumer demand; and South Korea, a proxy for the direction of the global economy for its export-centricity, sputtered on weak capital investment and slow growth.
That left the United States as the world’s economic engine. It has acquitted itself admirably, delivering in the second quarter the strongest GDP growth in years thanks to robust consumer spending, a strong labor market and red-hot corporate earnings growth. But as quantitative easing diminishes in the Federal Reserve’s rear-view mirror and as the tonic of across-the-board tax cuts slowly expires, the defining feature of the world’s largest economy will be a restrictive monetary policy. Rising interest rates have already undercut home and auto sales in the US, to say nothing of emerging market currencies.
We at Integrated Wealth Management (IWM) anticipate continued strong US growth for the balance of the year and we are confident the economy will evade recession next year. At the same time, we see little help from the developing world, to say nothing of the evolving one. Similarly, we are watching the proliferation of non-market risk – be it political, geopolitical or trade related – that could make a hash out of the most thoughtfuland well-researched forecasts.
We anticipate the Fed will raise rates two more times this year to a range of 2.25%-2.50%, against a forecast inflation rate of 2.75% and a 3.00-3.50% yield for the 10-year Treasury Note. As seen in the chart below, inflation has been steadily rising while wage growth has remained relatively flat.
Our estimate for two more rate hikes this year, followed by one or two more in 2019, is broadly in line with other forecasts. Some, however, see six more rate hikes from now through the end of 2019.
Concerns about inverted yield curves are, in our opinion, overdone as we regard inversion to be a consequence of quantitative easing rather than a late-cycle auger of recession. Having undershot corporate earnings in our preliminary estimates, we have elevated our outlook for the remainder of the year at 12-13% and 17-18% for the whole of 2018. We anticipate the S&P 500 (Large Cap) and the Russell 2000 (Small Cap) will finish up 11% and 12%, respectively, on the year – in line with our original projections. On the fixed income side, we maintain our forecast that the Barclays Capital US Treasury Bond Index will end 2018 down 2.50%. On the currency front, we expect the dollar to strengthen against the euro to 1.15 EUR/USD at year end due to continued EU weakness. We believe the USD/Yuan will end 2018 around 7.0, the subject of a deliberate devaluation by Beijing.
Lastly, we are sticking to our original 2018 estimate and anticipate oil (WTI) will stage a minor recovery from last year, from $60 a barrel to approximately $65 a barrel.
After posting a second quarter performance of 4.2% (revised upwards from the 4.1% advance estimate), we expect the US economy to downshift slightly to 3.0% on annualized basis fueled in part by historically low unemployment and energized consumer spending.
While we expect the impact of fiscal stimulus to continue through the second half of the year, we are watching closely the slow-down in the housing and auto sectors. For example, the gap between home prices and Average Hourly Earnings is almost as wide as it was in 2006, which means fewer buyers can afford to purchase a home in many cities. In addition, the percentage of consumers who think it is a bad time to buy a car due to high prices reached a 20-year high of 21%, according to a recent survey by the University of Michigan. Ripples like that in the economy’s two most important goods markets suggest that consumer confidence extends as far as wage growth can outpace inflation.
Having ended 2017 with GDP growth for the year of 2.70% and poised to accelerate from there, the European Union stumbled badly in the spring. We now believe Europe cannot manage more than 2.25% growth this year amid flat interest rates. Nor do we suspect Japan or China to take up the slack, as the former flirts with recession – according to research firm Capital Economics, Japan “faces severe labor and capacity shortages that make it difficult to sustain above-trend growth,” – and the latter contends with sagging manufacturing and non-manufacturing activity alongside depressed equity markets.
While we can only guess how deeply the emerging market mess will go – fortunately, we liquidated our emerging market exposure earlier this summer – we believe intuitively that its risk of contagion is limited due to a lack of critical mass. For example, as the IMF points out, Turkey represents about 3% of eurozone exports, equivalent to less than 1% of eurozone GDP. Turkish loans make up only a small proportion of eurozone bank lending and Turkish stocks constitute less than 1% of the MSCI Emerging Market Equity Index.
We see the developing world as a perpetual source of opportunity and instability. While they have advanced impressively over the decades, they have yet to earn international respect for their currency regimes, particularly in the face of rising interest rates in the developed world. Again, Turkey is the exemplar—they’ve been dipping into their reserves since 2013, which are now well below the IMF’s recommended levels. Only countries able to generate reliably large trade balances, such as China, seem to be immune to such pressure. And that practically puts the once-sleeping giant in a category by itself.
What’s more, though they have recently stabilized, we are still keeping tabs on emerging market currencies as the Fed continues on its tightening path and as debt levels remain elevated.
The Conference Board’s Index of Leading Economic Indicators is rising comfortably and that alone is enough to sustain a buoyant outlook at least for the second half of the year. However, we appreciate that even the most intelligent of forecasts could be made obsolete in minutes given the potentially seismic events facing the global economy and the endless news cycle that can transmit them. For example, while we welcome successful efforts to repair trade relations between the US and Mexico, the failure thus far of related negotiations between Washington and Beijing gives us pause. Similarly, the potential for a transfer of power in the House of Representatives following this fall’s mid-term elections could introduce grinding legislative gridlock and uncertainty in US policy. More ominously, if North Korea or Iran resume their nuclear ambitions in defiance of Washington, the market response – to say nothing of the potential human cost – could be staggering.
All or none of these things may come to pass over the next two quarters. In the neo-multipolar world, the safest bet is the unexpected.
SO WHERE DO WE GO FROM HERE?
The investment team at IWM is carefully watching these—and other—market and macroeconomic data points. After reviewing our forecasts and capital market expectations, we conducted a thorough and detailed review of our strategies, and made several portfolio adjustments in June, including reducing overall exposure to international stocks and overweighting the healthcare sector. We reviewed key metrics such as performance, and volatility measures to ensure that each new holding meets its stated investment objective within our larger target risk portfolios.
After much analysis and debate, our Investment Committee at IWM concluded the current overall strategy and holdings are well-suited for the world at hand. We identified nothing that rose to the level of challenging our high conviction positions and elected instead to be patient, but vigilant in a few areas. As mentioned before, we are mindful of the potential risks on the horizon and will react accordingly if circumstances sour.
YEAR END GLOBAL ECONOMIC AND MARKET FORECASTS
The investment team is constantly evaluating and re-evaluating both our current positions as well as our new ideas, and we will certainly keep you, our clients, apprised of any pertinent and material changes.
On behalf of the entire team at IWM, we greatly appreciate your support, trust and confidence as we navigate through these ever-changing financial markets. We encourage you to contact any member of the team to discuss these views, or any questions you might have.
All the Best,
David Young, CFA®
Chief Investment Officer, IWM, LLC
Brent Pine, CFP®, CPA
President & CEO, IWM, LLC
(480) 663-6000 (p)
(480) 663-6033 (f)
4800 N. Scottsdale Road, Suite 1900
Scottsdale, AZ 85251
*David Young is not affiliated with Geneos Wealth Management, Inc.
Securities offered through Geneos Wealth Management, Inc. Member FINRA SIPC. Advisory services offered through Integrated Wealth Management, LLC.
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