The developed world has a problem. Interest rates are too low, and they have been too low for too long. Therefore, investment markets will now have to navigate a period of rising interest rates, which may take many years to complete.
However, a positive result of this current low interest rate environment is that economic growth is occurring everywhere, and more so in the world’s larger economies. If credit is cheap, then capital will flow for investment and speculation. Both factors will drive growth, although investment sustains an economy more so than speculation.
So why are market traders, asset managers, investors and commentators so on edge? The answer lies in the uniqueness of this environment, combined with the lack of historic precedent upon which to draw predictions. Further, there is the overwhelming human trait to focus on the negatives (the risks) rather than the positives. Humans have a deep-seated desire for self-preservation, and when this is transferred to the investment arena in an uncertain period, it translates into a focus on capital preservation.
 

While capital preservation – which we define as investment with no risk and therefore no return – may be deemed appropriate for someone late in life, it is often a poor investment strategy. This is because inflation will erode the purchasing power of the capital and the capital will be depleted by consumption. The longer a “capital preserver” lives, the greater will be the real (i.e. after inflation) depletion of the supposedly preserved capital.
Capital needs to be invested and returns generated to protect its purchasing power and to limit capital drawdowns from consumption. This leads to a more logical investment thought process – “capital maintenance” – for mature aged self-funded retirees. With this strategy, investments are made to generate enough cash returns to meet the investor’s consumption needs. Rather than being short-term focused, this strategy acknowledges the inherent volatility of listed growth assets whilst capturing the higher yield offered on unlisted income securities or direct property.  The blended portfolio dampens down volatility and exhibits longer-term growth in income.
With the slight change of investment focus from preservation to maintenance, comes the understanding that there is more to investing than focusing solely upon equities. When there is a heightened concern with equity valuations, an asset adjustment can and should be made to focus more on yield than capital gain.
It is this point that much financial commentary fails to acknowledge. In our view, there is too much commentary focused on the outlook for equity markets. It is “black and white” commentary, mainly by equity managers, for whom are left with their investment option as a choice between equities and cash.
However, the investment options are in fact much broader; balanced investors with a multi-asset portfolio will be far less bothered by the doomsday headlines that are peddled by equity market players.
This introduction takes us into a deeper review of the macro environment and the current outlook across asset markets – much of which is focused on the following issues:
1. The deepening trade tension between the US and China;
2. The adjustment of US interest rates to more normal settings which in turn will be followed by other developed economies – et to hit 5% of GDP in 2019;
3. The burgeoning US fiscal deficit;
4. The unravelling of European monetary policy an QE is wound down;
5. The risk of Chinese growth slowing; and
6. The emergence of inflationary signals as oil prices lift and non-USD currencies devalue.
Our observations
The economic environment is seldom benign – it constantly ebbs and flows. Long-term growth is periodically checked by the occasional cyclical recession or financial mismanagement. But for most of the time, economic growth is occurring and it is important to focus on investment opportunity whilst retaining a careful eye on risk. Elevated risk is more likely the result of stretched pricing rather than the risk of recession.
Our observation is that at present there is no evidence to suggest that the world economy, or specifically the powerhouses of the US or China, are about to fall into a recession or major downturn.
That is important because market commentary often mixes the forecast of a recession with the observation of high asset prices. The former will lead to a substantial fall in growth asset prices and it is not a common occurrence. The latter usually leads to a more moderate correction in the price of growth assets that were excessively priced above fair value and is the more common pattern of the ebb and flow of markets (alternating between greed and fear).
If there is not a recession on the horizon – and that is our view – then the sensible approach is to invest across asset classes and avoid excessively priced assets. There should a clear outcome-based objective for returns over a reasonable time frame. The overwhelming human desire for self-preservation needs to be pushed against with comfort created from diversifying across asset classes.
However, we are concerned by the fiscal situation in the US and we believe the markets are somewhat complacent about this. We are also concerned with the trade dispute between the US and China whose repercussions seem to be excessively magnified by equity price declines in China.
So why do we perceive that the current asset price corrections – particularly in bonds and equities – is just that, rather than an indication of an impending global recession?
Simply because the growth of China, followed by India and other emerging economies, is too significant a force. These economies will grow for decades to come and it will only be reckless financial management, mainly in developed economies, that will slow or upset this growth and only for short periods. Long-term growth is predictable whilst short-term price movements are not.
Our view is that the current correction in equity prices across the world presents an opportunity to diversify prudently away from the US equity market. Indeed, as the US fiscal situation comes into focus in 2019, US equity prices may adjust (against higher bond yields) while the Chinese equity market recovers from an oversold position.
However, we remain sanguine on bonds and the bond price correction is of less interest because generally, bonds are still very overpriced. Their yields are too low.
Let’s deal quickly with the six factors outlined above and draw some other conclusions for investors.
First, the US trade deficit continues to deteriorate as President Trump undertakes his trade fights with Mexico, Canada, China and Europe. Although we acknowledge that some of this short-term deterioration would have been caused by US importers pushing orders through prior to tariffs being imposed.

While the NAFTA deal has seemingly been concluded, the new NAFTA is reported to be not much different to the old one. Some adjustment to Canadian dairy protection and support for US automobile production away from Mexico, are the key changes.
Meanwhile, the imposition of tariffs on Chinese imports has been aggressively imposed prior to any significant trade discussion with them. We are of the view that Trump’s short-term focus is on the mid-term elections in early November and a China trade deal will flow after this.
The adjustment of US interest rates to what are more normal settings is continuing as the economy powers forward. However, it is also occurring as the fiscal situation deteriorates.
The adjustment to interest rates by the Federal Reserve is logical given the growth in the US economy and the sustained growth in employment exhibited in the next chart. US payroll growth continues at a great pace and last week it was confirmed that 560,000 jobs have been created over the last 3 months.

Concurrently basic wages are growing in industrial sectors that have not seen growth in a decade. An example is Amazon, which announced that its minimum wage rate would lift to $15 an hour from 1 November.  The move will impact 250,000 current employees, plus 100,000 seasonal workers. That rate exceeds the federal rate, which has remained at $7.25 an hour for nearly a decade.
In the illustration below, we see a world slowly turning red – countries projected to increase rates over the next 15 months. At present, relatively few countries are lifting rates, but this is likely to change in 2019 when Europe, Australia, India, Brazil and South Africa are projected to join the US, Canada and others.

The forecasts above do not describe the extent of interest rate increases – which we expect will be both modest and deferred – and they suggest that China will lower rates as its economy adjusts to US tariffs. The point must be made that China retains plenty of economic firepower with fiscal stimulation and interest rate adjustments at its disposal if needed to sustain economic growth at 5 to 6%.

Meanwhile, the US fiscal budget for FY18 concluded on 30 September with an estimated deficit of US$782 billion or 3.9% of GDP. Over the past fiscal year, government tax receipts are estimated to have risen by a mere 0.4% whilst corporate tax receipts fell by a staggering 31% as tax cuts and instant capital expenditure write-offs were utilised.
On the spending side, outlays lifted by just 3% and indicate that the budget deterioration from a deficit of US$666 billion in FY17 was totally driven by the Trump tax cuts. Further, it will get worse in 2019 when the budget deficit is predicted to reach 5% of GDP.
In passing, we note how the Italian bond market reacted when the Italian Government proposed that its fiscal deficit will be 3% and well above the Eurozone target of 2% for 2019. The Italian bond yields jumped sharply, and we expect this will occur in the US as well in coming months.

While interest rates are rising, we must remember that central banks are cautious and will adjust cash rates very slowly. This supports our contention that a recession is not imminent as central banks will continue to maintain supportive policies as bond prices weaken.
The recent surge in the USD (and therefore depreciation of other major currencies) acts as an economic stimulant for most of the world – albeit with some inflationary risks. In any case, many advanced economies are desperate to see inflation as it will stimulate both investment and consumption; a perception of rising prices will drive investment in stock or working capital and this, in turn, lifts production.
The correction in bond yields (upwards) may appear significant but it really isn’t at this stage. For instance, consider the recent blip in Japanese bond yields which is magnified by scale. Japanese ten-year bond yields have moved to just 0.16% pa which is their highest rate in 2.5 years.

The recent pressure on the AUD: USD exchange rate is driven by the following chart which shows that the yield on Australian ten-year bonds has fallen to the largest discount (relative to US Treasuries) in 25 years. Australian bonds are trading at a 0.5% lower yield than US ten-year bonds and, given the US fiscal outlook, this spread will widen.

The spread between US bonds against German and Japanese bonds is reaching levels not seen for a decade. This suggests that USD strength is likely to continue until President Trump addresses the burgeoning US deficit and settles the trade dispute with China.

Our final chart reiterates our current major concern for bond yields in the US and why we remain cynical towards government bond prices across the world. The supply of bonds continues to grow.
The chart from Moody’s outlines the percentage of government budgets (expenditure) that is used for the payment of bond interest, and it clearly shows that the US (along with Italy) is amongst the world’s biggest payers of interest and this will inhibit its ability to balance its budget.

In our view, the US fiscal position is unsustainable and if Trump does not adjust his budgetary settings, (which can only occur through reversing the tax cuts), then the US is heading for a fiscal problem as the Federal Reserve lifts interest rates throughout 2019.
Higher interest rates will lead to higher bond yields and consume more of US budget outlays, creating a negative reverse loop. And this will occur at a time when US growth should be resulting in a balanced US budget.
Hence our view that it will be poor financial management, in major developed economies, that threatens world growth in the short term, whilst the longer-term growth outlook is unstoppable in the developing world. Thus a balanced investment approach is required.