CAPTRUST Chief Investment Officer
Fall reintroduces many welcomed events; the new school year (perhaps welcomed more by parents than kids), football season, cooler weather, and while maybe not as recognized by the mainstream, Nobel Prize season. As each prize is awarded, one cannot help but marvel at what contributions Nobel Laureates have made across important societal bedrocks. Since 1901, over 850 individuals and 25 organizations have received Nobel Prizes in physics, chemistry, medicine or physiology, literature, peace, and the economic sciences (added in 1968).1 The Nobel Committee faces difficult decisions when selecting winners and their statutes allow for joint awards.2
This year’s prize in medicine or physiology was awarded jointly, with the first half presented to British-American scientist John O’Keefe for identifying nerve cells integral in creating a mental map that helps humans establish a sense of place, and the second half going to a Norwegian couple who discovered separate nerve cells that help with navigation.3 The two winners’ collective efforts have been dubbed by some as the “mental GPS” or global positioning system prize.
While the Freedman family was not consulted by the Nobel Committees, we endorse any prize mentioning what has become our favorite acronym. With the three of our children attending separate high, middle, and elementary schools, each playing driving-intensive and mostly nonoverlapping sports, we have long been reliant on our mental and mechanical GPS systems. We discovered you can change the language and dialect of the voice barking instructions at you; after trying several combinations, our middle daughter Elle grew particularly fond of Garmin’s Australian English voice delivery, and we affectionately named our Garmin “Barbie.” With her merged, unstressed vowels and soft “r’s,” it was hard to get mad at Barbie when she repeatedly implored us to make a legal U-turn after going off the highway to refuel or (gasp) not following her instructions. While Barbie is all but retired now (in desperate need of a map update and soon to be fully replaced by phone apps), “she” helped my fellow Northeast transplant wife and I traverse many a weekend event across the American Southeast.
As autumn rolls in, investors’ spatial mapping may also require an update. Quite simply, the narrative guiding global capital markets appears to be shifting, and while financial pundits, including yours truly, do not know exactly where we are headed, we do know a few key variables pacing future direction. First, central banks, including the U.S. Federal Reserve, the Bank of Japan, European Central Bank, the People’s Bank of China, and the Bank of England, remain the critical capital market drivers; their pro-growth policies have at least partially (some would say completely) fueled strong performance across major asset classes like bonds, stocks, and parts of the commodity market. Second, as we have written in the past, global growth prospects remain very uneven across regions, but recent data across key regions suggest that growth prospects have diminished. Third, the U.S. dollar has appreciated materially relative to most of its major trading peers, a phenomenon with far-reaching implications. We will explore these three issues and talk about their investment implications, but collectively these issues place capital markets at a proverbial crossroad and investors need to respect these important variables.
Central banks had a near uniform response during the financial crisis. As highlighted last quarter, my son’s birthday (August 17, 2007) coincided with the U.S. Federal Reserve’s first reaction to cracks beginning to show in peripheral lending markets; 13 months later, as the crisis enveloped the entire banking system, almost every other central bank reacted en masse. Central bankers and government officials waged war on economic threats with interest rate cuts, asset purchase programs, guaranteed lending programs, and other tactics never seen on such a global scale. Policymakers were adopting unprecedented measures, treading down roads their proverbial “Barbies” had never seen.
Immediately following the financial crisis’ deepest chasm in late 2008 and early 2009, central bank activity remained relatively consistent across major players, but over time major central bank policy diverged as economies began to repair. For example, the U.S. Federal Reserve, regarded as one of the more responsive and creative central bank actors, instituted three separate quantitative easing (QE) programs since 2008. QE is effectively open market purchases of securities made with the intent to reduce borrowing costs and stimulate demand. The third and latest installment of QE is slated to end in October. Despite its desire to cease open market purchases, the Fed has maintained interest rates near zero since 2008, reflecting its desire to keep borrowing costs low for consumers and businesses. The United Kingdom has followed a similar path, although the Bank of England has already ceased asset purchases.4
Japan and Europe have followed different paths than their U.S. and UK central bank colleagues, with the former intent on continued pro-growth easing to stoke decades of stagnant economic activity and the latter hoping to avoid a Japanese fate. Japan has adopted pro-growth policies by political mandate; Prime Minister Shinzo Abe was elected in late 2012 on a platform of stimulus spending. Europe has been more skeptical of broad-based stimulus and due to its more fractious composition (politically independent countries with a common currency and monetary policy), its largest economic constituent, Germany, wields considerable influence. Germany has long rejected widespread asset purchases for fear of government deficits and rampant inflation. German Finance Minister Wolfgang Schauble insists that Europe needs more economic restructuring (labor laws, trade policies) rather than more government spending to jump-start its economy. Finally, the People’s Bank of China appears to be in a more reactive mode, noting in its last market communication that it will “follow the requirements of making progress” while watching current developments.5 The world’s central banks are in very different places. But the shift in the United States, namely a transition away from quantitative easing and an increase in interest rates (expected in mid-2015), is most notable due to the U.S. economy’s size and the psychological effect of transitioning to higher interest rates.
While the Fed has signaled its transitional intentions since late 2013 when the global economy was ramping higher, the global outlook seems to have shifted in recent weeks. European economic data has been discouraging, with persistent unemployment and stagnating manufacturing and service readings, as well as weakening conditions across Germany. Chinese manufacturing and services data has also disappointed, and Japan is absorbing a consumption tax enacted in April. Emerging economies are still growing but at a slower pace, and a European slowdown would impact their outlook. Should outlooks deteriorate from here, central banks may be forced to rethink their policies, but given the Fed’s strong signals for almost a year about its intentions to wind down QE, it may be hesitant to change course.
The U.S. dollar has also added complexity to outlooks, rising to a four-year high relative to its major trading peers as seen in Figure One. This development has mixed implications for the global economy. While it does make foreign goods cheaper for U.S. shoppers, it also causes U.S. goods to rise in price for non-U.S. consumers. Since commodities ranging from oil and gas to grains to cattle are quoted in dollars, a rising dollar makes these goods more costly for nondollar holders. Based on some of the more tenuous outlooks mentioned earlier, this is not an opportune time for foreign consumer costs to increase.
Given the world’s divergent GPS with respect to growth outlooks and central bank activities, what should investors do? We still see a favorable overall investment climate, but anticipate an uneasy transition away from an actively pro-growth Fed, a global economic backdrop switching from uniform growth to select regional weakness, and a capital market environment that has shifted toward investment in riskier asset classes like global stocks and high-yield bonds. We have been consistent in telling clients that now is not a time for portfolio heroism; a Fed-fueled investment environment with global growth on the upswing and underinvested portfolios getting back into global stocks was last year’s story.
While we are unlikely to receive a Nobel nomination for recommending clients remain diversified, times like this require investors (and their advisors) to take an extra-hard look at their portfolios. If you have an actively managed bond strategy, will the manager’s underlying positioning help if regional weakness morphs into a full growth scare? On the other side, if growth expectations increase, is your portfolio invested in a way that will capture the higher probability outcomes? If we can help update your portfolio GPS in any way, please don’t hesitate to let us know.
Just please don’t ask for Barbie’s help; she’s been bronzed, mate.