In recent years, at our internal research meetings, we have discussed when the US economy would experience the later innings of the business cycle, and whether we would see the classic signposts that denoted the end of prior cycles. Our concern was that the longest running experiment in monetary policy would extend the low growth economy indefinitely, never getting too hot or too cold, but overshadowed by a consumer or business cycle that never really got going. These concerns have dissipated in recent months and we are beginning to believe that the current cycle may actually follow the classic scenario after all. Increasing inflation expectations, and escalating consumer and business confidence numbers could suggest that people are feeling good (again). These trends typically signal late stage – but even late stage can take some time.
The first quarter was a classic risk rally, in that markets with high risk premiums delivered high performance, i.e. emerging markets led, followed by international developed, followed by the U.S. Only a modest 2% gain in U.S. small caps would refute the above, but investors did receive a healthy 21% return in 2016. There were catalysts beyond simply risk taking that explain the international out performance (weak dollar for example), but there has been a renewed appetite to exploit risk premiums globally. It is unusual to see all of the major markets rowing in the same direction at the same time, leading us to believe that there will be greater separation in the near-term.
As we get closer to the second half of 2017, there are some divergences that are worth commenting, specifically, diverging trends in fixed income and equity markets. While U.S. equity markets hover near all-time highs, fixed income yields are headed lower, signaling, perhaps, that expectations for real economic growth or inflation are going to disappoint in the future. This is at odds to equities, which are expecting improved growth and inflation going forward. Which side is correct? We do believe that the deflation trade of recent weeks will be short-lived. A cautious Fed that likely will not hike three times this year, numerous future fiscal policy initiatives (tax reform being the more important), and optimism abroad that the US is growing again, should be enough to deliver a solid year to equity investors. Policy remains the key risk, specifically, whether the administration can deliver on the rhetoric, a tall task given all that has been floated. If successful, the current cycle could extend further.