Chief Investment Officer
We were somewhat bemused when the Fed upgraded their assessment of the US economy at their FOMC meeting last week. Events must have occurred between December and January for them to announce this upgrade and it can only be because they expect the consumer to spend the “tax cut” from lower energy prices. They may also believe that employment gains will continue despite news flow from the corporate sector that would indicate otherwise.
At the moment, we see two competing forces within the US economy. On the one hand, the consumer and non-energy corporate sector are much better off because of lower energy prices. If they choose to spend this windfall on domestic consumption, then there is very good reason to believe the US economy will continue to muddle through quite nicely. On the other hand, the energy sector has certainly boosted the US economy since the financial crisis and has created lots of high paying jobs with wonderful multiplier effects. Furthermore, up until last summer, it can be argued that the US Dollar was undervalued and this also benefitted the multi-national corporate sector. With the collapse in the price of oil and a near 20% rise in the US Dollar, the corporate sector is now a potential risk for the US economy.
There are enough commentators that argue whether Fed policies have created a financial bubble. We think that part of this bubble may include executive remuneration in the quoted corporate sector. By this, we mean that executives receive the vast majority of their overall compensation via share options and, as a result, do everything in their power to boost the share price of the companies they work for. The obvious mechanism is share buybacks (see first chart below) but the gaming of earnings expectations every quarter, the strenuous use of reporting vs GAAP earnings, the lack of capex (which is earnings negative short-term but would improve corporate performance long-term) and the use of flexible labour policies also contribute to a remuneration bubble phenomenon. For those who want to read more, Andrew Smithers has written extensively on this subject in both his FT blog and his recent book.
So, our biggest concern is whether the bursting of the energy sector alongside a bursting of the executive remuneration bubble will hurt the economy before the US consumer really has time to spend their windfall from lower gas prices. We argued mid last week that the risks to the US economy were on the downside. The advance estimate of US GDP released on Friday indicates that this may be happening already. Growth slowed from 5% in 3Q to 2.6% in 4Q, and although consensus estimates have growth in 1Q and 2Q to 2.8% and 2.9% respectively, we think the risk could easily tip to the downside on these estimates.
Non financial companies have been THE major buyer of equities in recent years (see chart below). Therefore, if buybacks suddenly slow as the economy stumbles then this could easily cause equity markets to correct lower. In fact, with the S&P now no higher than in the last five months and the NYSE composite the same level as 11 months ago, we argue that the market is losing momentum and is now more vulnerable than since 2011
If the equity market does enter a bear market in 1H this year, then with the potential negative feedback loop to the real economy, the risks of a recession escalate sharply. That said, the US consumer has confounded expectations before and could come to the rescue in 2H this year but how much, if any, damage will be done by then?
For our part, we remain very defensive in our portfolios. We think that the Fed is too optimistic and will be forced to keep rates on hold this year which should help rates and bond markets which is where we have focused recent investment in the RMG Real Return Fund. Equity markets are vulnerable in the US and we (marginally) prefer European and Japanese equities where the Central Banks are printing. In FX, we are absolutely seeing currency wars with 14 central banks having eased policy so far in January (Denmark three times in two weeks!). This should be fertile ground for active managers such as ourselves and is how we have positioned the RMG FX Strategy so far this year.