Chief Investment Strategist
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Higher interest rates, tariffs, and an absence of new tax cuts will marginally slow US growth in the coming year
The US expansion is getting older and the Fed is ever tighter. This impacts every global asset class to some degree and suggests a gradual shift to a more defensive asset allocation over time. Nonetheless, the drop in global shares in the past 24 hours is following the course of many routine corrections that have been followed by recoveries. We don’t advise properly diversified investors with multi-asset class portfolios to sell into such a disorderly panic. Those under-allocated should look for opportunity.
Near-term implied volatility for US equities has doubled in just over a week. Ninety-eight percent of all global equity markets fell in the past day (67% with a drop larger than 2%). Sector and stock correlations spiked, consistent with indiscriminate selling. Even if the declines continue as severely as the January 2018 case - or the two cases in 2016 before it - such drops are about 5x more frequent than lasting bear markets consistent with economic recessions (typically, these are full year periods of corporate profit declines).
US interest rate pressures were indeed the proximate catalyst for the sudden lurch lower. At the present state of the US expansion cycle, boosting asset prices is not consistent with the Fed’s actual mandates of price stability and maximum employment. Effectively tighter financial conditions can make the Fed reconsider its tightening path, but only to the extent that it pushes the US economy away from its potential.
Thus, the days of accelerating growth, firming inflation and extraordinarily easy US monetary policy are over. The absence of a strong “flight to quality” bid in US Treasuries yesterday illustrates the new reality.
Higher interest rates, tariffs and an absence of new tax cuts will marginally slow US growth in the coming year. Nonetheless, we still see a healthy US growth rate above 2.5% in the coming year with further gains in profits. Room for a dramatic US expansion beyond that period is unlikely in our view.
US large cap shares sharply outperformed non-US equity markets (and US small caps) in third quarter despite globally-pervasive concerns over tariffs and trade friction. We believe tax-cut-driven US share repurchases have been a critical factor in this performance. The absence of repurchases just ahead of 3Q EPS results (given regulatory restraints) may have been an additional tipping point for markets. Repurchases will resume in full in the coming month.
Global markets also ‘tripped’ in January on spiking US interest rates, just ahead of strong US earnings results. They didn’t recover fully for months given much surprise over US trade actions that followed by March. We expect another quarter of strong earnings results just ahead. This time, there may be considerably less fresh negatives to consider on the trade front to hamper recovery.
While select US bonds deserve full or overweight allocations, many international share markets will shine when correlations normalize. However, this will be more strongly felt over a long-term horizon. The weakness in the US dollar today is an added signal that US markets have been highly confident and investors, much more bearishly positioned abroad. Regardless of justifications, US markets will have to live with consequences of the trade war which we see as important to US corporate profits.