Time to compare investment opportunities for the year end
As we enter year end, it is always good to reflect on what got us here and ask ourselves some hard questions as we enter 2018. To do that, we must incorporate a pragmatic framework to our thinking.
What will happen to Trump?
Overall, the Trump legislative agenda has been a dramatic failure. His administration’s last ditch effort to salvage a tax package is egregiously one-sided to the rich. Sadly, Trump supporters seem to be the last to understand that.
Assuming its passage, which looks likely, the tax package will cause the bond markets to seriously reflect on their appetite for debt from a nation that refuses to take its deficit seriously. My expectation? Much higher yields.
Be advised, the impeachment discussion is a distraction...watch bonds.
What about the bond market?
The absence of inflation has allowed participants to grow complacent about higher yields, yet the basis is there for much higher interest rates.
This will have a dramatic effect on two things. One, the Fed’s initial gameplan to increase rates and two, the Fed’s plan to lower its balance sheet. Both of these initiatives would have, in the absence of the tax package, caused higher interest rates. With the tax package, the President may have aggravated the scenario for the US fixed income market to sell off.
The hard question to ask is whether or not the US consumer can withstand higher rates? The simple answer is no
What then of currencies?
The US has enjoyed calling China a “currency manipulator,” but the hard reality is that the US is the real culprit.
With ~2.5% GDP growth, the US is well below the target of 3.0% required for Trump’s economic assumptions to be successful. If there is no true GDP growth, what options does the US have? Devalue the dollar.
Mind you, we will never hear Treasury Secretary Mnuchin say this on TV on-air, but it is in everyone’s interest for the US dollar to decline.
Where does this leave equities?
Here is the inherent irony of the markets. From a valuation perspective, equities are expensive in any market today. On a relative basis they are less rich in Europe and Asia. From a sector perspective, financials remain cheap.
But this premium has had no effect on the momentum trade we are witnessing. Momentum is a polite way of saying that we are in a “Bitcoin trade” right now in this market. People are buying because people are buying.
The challenge with momentum is that when it stops it is BRUTAL. However, it is exceptionally difficult to sell in front of a momentum market.
Near term, I expect momentum to continue (to my own chagrin). But, the pressure from both the fixed income and currency markets will inevitably place too much pressure on US equities. That then will cause a selloff…one that is long overdue.
Conclusion
At a minimum, use year end to pare back your portfolio back to their target weightings. From a weighting perspective, look to keep your bond durations short, avoid US Dollar exposure, and underweight US equities relative to Europe and Asia.
This tactical plan will help you navigate this momentum trade. But you will need to be an active watcher of your portfolio.
Watch the fixed income market as your signal. Any market hiccup, downgrade, default, etc. will be the catalyst for the end of the momentum trade, and the beginning of a protracted global sell-off.
Then, sadly, all bets are off.