“It was the best of times, it was the worst of times”, wrote Charles Dickens as the opening words of his historical novel “A Tale of Two Cities”. Using his characters and historical events, Dickens examines the contrast of good and bad, and weaves in a specific story line of redemption in the midst of rebellion. We believe the current economic and investment environment reflects a similar story of disruption and redemption. We begin our tale at the start of the new year, with stock markets on a tear and without so much as a hint of a correction. Here in the US, unemployment is at or near decade lows, GDP is improving, and we are seeing a slight uptick in wages. All good things. As a matter of fact, things are looking solid enough that President Trump made an appearance at a gathering of international business and political leaders in Davos, Switzerland, to promote America as an attractive destination for foreign investment. The sighting of a sitting US President in Davos is a rare thing. (The last sitting President to appear at Davos was President Bill Clinton.) And somewhere along the way an interesting thing happened.
Disruption: Secretary of the Treasury Steve Mnuchin, who accompanied President Trump to Davos, was quoted as saying that America was not concerned about the recent decline in the value of the dollar. The dollar had already declined 10% in 2017 and was down an additional 2% for the month of January. That seemed like a pretty innocent statement, right? What’s the harm of a weak dollar? Well that depends on what side of the dollar your interests lie. A weak dollar gives US companies cost advantages as they sell their products in other countries. For example, a European consumer would see prices for American products fall in Euro-terms. And foreign companies find that their goods become more expensive in the US as their currencies strengthen against the weak dollar, helping American companies that compete against them. Essentially, the weak dollar acts like a tariff or tax to our trading partners.
Mnuchin’s comment sent shock waves throughout markets as it increased concerns that the Trump administration would pursue protectionist policies through a weak dollar and that this could damage the recent improvements we have seen in global growth. Not long after this comment, Mr. Mnuchin had the opportunity to walk back his statement and ease the fears of the investing public. Unfortunately, it was to no avail. Now add to that the market’s new-found inflation concerns. Recently reported wage increases raised fears that the Federal Reserve and its new Chairman Jay Powell may have to raise rates faster than previously thought. The combination of these things generated a giant spike in market volatility, and over the next 15 days equity markets fell nearly 10%. This all came off the heels of a very strong start that found markets up over 6.5%. Fears over inflation, concerns about volatility, and US global policies sent the markets tumbling. But, had anything really changed?
Redemption: In our view this is not all bad. The Federal Reserve has been trying to generate inflation since the Financial Crisis, and yet it still sits below the Fed’s target almost 10 years later. The recent wage data suggests some success in that effort, and growing wage income is generally seen as a positive in that it helps stimulate the economy. An important driver of the wage data is the rebound in the global economy that began in the summer of 2016, which has also helped bring down the dollar’s value. And we have not even mentioned the economic tailwind created by recent corporate tax cuts and the potential for US global companies to bring home profits held abroad.
Inflation is certainly something we have been talking about for a while. Investors’ fear of inflation might be early, but the fear is not misplaced. Inflation leads to higher interest rates, and higher interest rates lead to recessions. But we think we are a long way from a rate-induced recession. We believe that renewed fears of rising inflation are disrupting the status quo, and with that disruption comes opportunity. And in our “Tale of Two Cities” we still look for the redemption of the markets. We still believe that the tailwinds of global growth, and the aforementioned stimuli will support equity markets over the next few quarters. And the bumps along the way will provide the opportunity to move from the “winter of despair” to the “spring of hope”.