RCM Managed Asset Portfolio - Q4
Current Economic Environment
I’m going to begin this quarterly talking about the economy. As it now stands, we are more cautious on the economic front than we were last year. While the economy still continues to grow (2.1% last quarter), there are a number of signs that might show weakness in the equity market.
One reason for long term caution is the yield curve. In August, the 2-10 year Treasury yield curve inverted. On average, a yield curve inversion has occurred 20 months prior to a recession. What usually occurs after a yield curve inversion is that the yield curve begins to steepen. This often leads people into thinking the economy has returned to normal and the perceptions that initially caused the inversion have been removed. However, an inversion of the yield curve generally signals a coming recession.
The second reason for some caution is credit conditions. Credit conditions often speak to business health and confidence, specifically the ability of businesses to meet their debt obligations. Credit conditions continue to be fair overall. In the better credit grades (blue line), spreads have narrowed. But spreads have not improved greatly in the weakest part of the credit market. Looking specifically at the poorest high yield credit (red line), spreads have not narrowed as equities have risen.
This would indicate that the bond market is taking a dim view of the least creditworthy corporate borrowers. It shows signs that the riskiest parts of economy are weak.
Third, GDP growth is somewhat lower than last year and it is currently around 2.0% for the last four quarters. From what we have seen, when GDP growth decelerates, the performance of the equity markets tends to lag the periods when GDP growth accelerates. When GDP growth decelerates below the 2% level, equity markets do not perform well. The question for equity investors is whether GDP growth can accelerate beyond its current trough today, just as it did when it troughed in 1995 and reaccelerated to close out the last century.
To examine that question, you have to look at what causes growth to occur. Growth in the U.S. economy, or any economy, is based on three main factors. The two main ones are labor and capital stock. Capital stock simply means equipment and structures used for production, or factory equipment. Then there is a third factor called total factor productivity, which is an academic term for technological progress and efficiency.
The two main factors—labor and capital stock—always have to be present for any economy to grow. The combination of these two factors is the reason why a poor country such as Bangladesh has grown GDP at 6% for nearly a decade. Bangladesh already had an ample labor force. When provided capital equipment through foreign investment, its workforce became more productive. It is the same reason why mainland China (after opening up to the West in the late 70’s and adopting more of a market system) was able to grow GDP at such a high rate for the last four decades. The labor supply which had always existed was finally able to find the foreign investment and political stability necessary for economic conditions to flourish.
For developed economies, like the U.S. and Japan, which already have high levels of capital stock, growth is often dependent not so much on capital stock since this can’t grow that much further, but on labor growth and technology gains. Unfortunately for Japan, its population is not growing due to low birth rates and restrictive immigration policies. And so it has endured not only a lost decade but almost three lost decades now.
Circumstances are different in the U.S. where labor supply continues to grow consistently because of immigration and birth rates. But like Japan, changes in U.S. GDP are usually a result of changes in participation of the labor force. When people aren’t working and unemployment is high, then capital stock is idling, and GDP is shrinking. Conversely, when more and more people are entering the work force, capital will be put to work, and GDP will generally be rising. Our current decade-long period of GDP growth (and subsequent bull market) is a result of this long decrease in unemployment, with the largest gains in GDP occurring after the unemployment rate has declined the most. (See chart below.)
This leads us to the current environment where unemployment is now at multiyear lows. As seen below in the weekly initial unemployment claims, we have now reached a level where unemployment has not gone much lower for the past year. Initial unemployment claims are flat. Everyone who wants to work can find some kind of work, even if it is not ideal. (See red circle.)
But if much of the labor force is already working, there is little left on the sidelines to come in to boost GDP. It is possible that GDP growth can come from increasing the amount of capital stock. But, again, that’s difficult in a developed economy which already has ample capital, and in the U.S. capital expenditures have been modest the past two years. Historically, this flattening of the initial unemployment claims eventually leads to decelerating GDP growth because the economy runs out of new workers to continue the economic cycle.
Based on this reasoning, we can also see from this chart why GDP continued to grow after fears of a slowdown in 1995. In 1995 there was still another leg down for unemployment to go, meaning still another group of people who had not yet been working inserted into the labor force (green circle). This, along with technology gains from the PC revolution and the Internet, led to another push of GDP growth for the last half of the 1990s.
This isn’t the case with labor today with the economy seeming to push the limits of available labor. Of course it is possible that there is another leg down in unemployment, but it is not likely. We are already at historic lows. It would therefore be left up to technology gains to become a larger factor in GDP growth going forward. Absent this condition, GDP is not likely to significantly reaccelerate from here. And as we said previously decelerating GDP growth is generally not good for equity markets.
Current Market Environment
Instead of lower unemployment working to push GDP and equity markets higher, There have been other catalysts to the equity markets in the last quarter, including:
- Fed QE? For the past year the Fed has been lowering rates. This makes borrowing easier and supports credit markets. In addition to this easing, the Fed has also been providing liquidly to the short term Repo markets, which may be boosting the stock market.
- Reduced Tariffs. The current administration continues to negotiate trade terms with China. The expectation that a trade war is affecting global growth has been one of the causes of the market declines during the last few months.
- Hope of global growth. On the global front, growth in Western Europe (esp. in Germany) has slowed. The threat of still lower growth has likely been the cause of the market declines during the last few months. However the expectations of a rebound have boosted equities globally.
- Government. Domestically and abroad national politics continues to demand attention from equity markets. We see sensitivity to national politics as an enduring feature of equity markets globally, given the fiscal balance sheets of developed and emerging economies. However, resolutions to the Brexit standoff and a clearer view on the 2020 U.S. presidential election are providing optimism to the stock market.
- A Rebound in Domestic Industrial Production? This indicator has been telling as a precursor to economic slowdowns and some major market sell-offs. Note how industrial production tends to be in a downtrend whenever the economy enters recessionary periods. While there has been a slight but noticeable downtrend in industrial production since the start of last year, there has been a slight rebound and it does not appear a recession is imminent from this indicator.
Gov’t, High Credit Corporates
The Fed has lowered the Fed funds target rate to a range of 1.5-1.75%. As a result, bond prices, especially longer dated issues, have maintained their price rises. Last year we had reallocated to longer-dated corporate holdings in the mutual fund program and exited our allocation to floating rate bonds. Our bond portfolios have therefore done well. We knew that a halt of rate raises would be positive for bonds. But the performance of bonds this year has been historically good, perhaps better than anyone might have expected.
We will continue to hold this position until either (1) there are signs of a definite break down in credit conditions, which would signal an onset of a recession, or (2) there are signs of inflation, in which case the Fed would be compelled to raise rates.
Credit conditions still remain fair in most sectors of the high yield market, with those bonds rated CCC performing the worst. This may reflect future weakness in the overall high yield market. It should also be noted that about half of the investment grade bond market is B- rated, that is, barely investment grade and on the verge of being high yield. Some of this would surely be downgraded to high yield status in a recession.
Investments in the high yield market represent riskier investments along the risk spectrum. We expect this sector to be among the most vulnerable to any volatility whenever the downturn comes. We therefore hold little to no direct investments in the high yield market. But this market will also be among the fastest to recover in any recovery of credit markets. We anticipate making a return to this allocation after prices have declined significantly at the end of this credit cycle.
Recent developments in Large Caps and Strategic Knight
Due to the outstanding performance of equity markets in the last quarter, we decided to increase our exposure to equities at all levels in our active portfolio, Strategic Knight.
Small and Mid-Caps
During the past quarter small and mid-caps continued their rebound along with the rest of the market. They continue to lag the performance of the S&P and NASDAQ. However, if the recent market performance and risk taking continues, we would expect they would close this gap in performance.
In the mutual fund portfolio, we are still underweight exposure to small and mid-caps. Unlike large caps, small and mid-caps tend to have more volatile performance and therefore are more vulnerable to swings in volatility. Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms.