For those who trade more actively or have a lot of portfolio turnover, it’s easy to get immersed in the minutiae of the chart and lose sight of the important macroeconomic drivers of the market – i.e., growth, inflation, liquidity. All three – stable growth, low-to-moderate inflation, and ample liquidity all remain in place. At the moment, the US is entering the early part of the late stage of the economic cycle, typically a period where growth tends to decelerate while inflation begins to accelerate. Central banks normally begin to worry about the possibility of rising inflation and start increasing interest rates to increase the cost of lending and increase the rate of return on cash to incrementally cut down on risk-taking and price destabilization. Growth is running above average and is peaking. Inflation is below target, with the core rate still under 2%. Central bank rate hikes and balance sheet run-off are decreasing liquidity to some extent but the recent jolt in liquidity from the changing of tax laws in the US is providing a boost of growth to the economy. With plenty of cash available among banks, corporations, and individuals, all of this is available to push asset markets higher. Asset markets are increasingly pricing in the possibility of four 25-bp increases in the Fed funds rate for 2018. Based on the fact that inflation isn’t yet a problem, this is probably more than necessary. With factors such as low interest rates, high asset prices, and fiscal stimulus being brought into economic capacity constraints, it’s becoming harder to get monetary policy right. On top of that, you have elongated durations of credit-based assets that render them more rate sensitive due to years of low, stable long-term rates, and disproportionately high rates of return on equity relative to cash. Corporate management teams took the opportunity to leverage up to take advantage of a cheap source of financing. This means financial markets are more sensitive to rates than they ever have been historically, so small changes in rates can add up to large swings in asset prices and cause detrimental effects on consumption-investment channels. Accordingly, the risks to tightening monetary policy are higher relative to keeping it steady. When policymakers get it wrong in the form of policy being excessively tight, that’s why you end up with recessions. Current valuations are baking in just slightly more than three Fed rate hikes for 2018. Naturally this is currently reflected in asset markets. If interest rates rise higher than what’s currently baked in, this can have an adverse impact on valuations. A significant rise in interest rates along any part of the curve can’t occur without disrupting asset markets, as virtually all assets are priced off rates, whether it be stocks, real estate, private equity, etc., and not just the asset class most heavily associated with rate changes (bonds). This was what the February 2-8 sell-off was all about. Markets fell due to circumstances that we are relatively late in the cycle when it comes to operating capacity versus operating rates. When operating rates begin to near capacity constraints, this will stoke inflationary pressure and produce higher interest rates. Often central bankers will come to view economies running above their natural capacity with statistics such as unemployment running below the theoretical natural rate of unemployment. You can see before the onset of each recession (gray area), once “full employment” was exceeded – i.e., the rate at which output and inflation are in equilibrium – we had a recession sometime thereafter due to price pressures that the Fed extinguished through hiking rates too aggressively. The February 2-8 downturn of 10%-12% was enough to attract enough attention, stimulated by fears of increasing borrowing costs and exacerbated by the short gamma unwind. A bear market and potential recession will come about if central banks fail to get the balance between growth and inflation right. This is why keeping rate hikes fairly moderate is the best path going forward. Historically, this hasn’t been managed very well and resulted in economic pain. Central banks have also been struggling for years to get inflation back to 2% and slow to recognize that other forces are holding it back. Unorthodox monetary policies in developed economies have switched monetary policies’ transmission mechanism from interest rates to financial market and currency channels. This has produced a compression of credit spreads, weakening of fiat currencies, and rise in equities. Despite this, inflation risks still remain low. You still see excess capacity in many labor markets, particularly the mid-range service sector in the US. Upper- and lower-class wages are seeing a boost. But middle class wages are still relatively stagnant. There’s still excess capacity in China and India. Commodity prices still remain relatively low, which limits upward pressure on corporate cost structures. Technology is altering the nature of the trade-off between growth and inflation, and e-commerce is changing the way consumer goods are transacted. This is overall a good thing for the consumer and putting a crimp in inflationary pressure. A 2% target rate inflation may have made sense 10-20 years ago, but likely isn’t necessary today when structural issues that prevented a downward compression of prices – for instance, monopoly elements in certain industries – are less embedded than they are today. Wage-related inflation is still cyclical but the cycle has been more elongated than usual. Now that central banks are tightening monetary policy and reversing policies of low rates and financial asset purchases, the monetary policy transmission will revert back toward the credit market (rise in yields) and rates channel. Yet excessive tightening in this economy is pointless and central bankers have to consider the trade-off between higher inflation, versus tightening too quickly and triggering a recession through a credit contraction. Even if all the beliefs about certain structural impediments to inflation are wrong and we do see 2.5%-3.0% inflation within the next year or two, it’s hard to argue that this is bad relative to the risk of over-tightening (compared to what’s baked into the yield curve) and causing a deceleration in growth. The shape of the yield curve matters as well, as high overnight lending rates and low back-end rates produce a constraint on lending. The risk/reward trade-off is therefore against the idea of tightening too quickly. For asset markets to handle increased rates more than what’s currently priced in, growth and earnings will need to increase in tandem otherwise asset market will underperform relative to what’s implied by their risk premiums. What does the current economic backdrop mean for certain asset classes? Bad for Bonds After some $15 trillion in central bank buying, we’re currently going into the reverse part of this cycle. Bonds are facing headwinds due to a mismatch between supply and demand. There’s the Fed balance sheet run-off (and upcoming run-off from the ECB). More importantly is the fiscal deficit, which requires bond issuance from the Treasury to plug the budget gap. This is a lot of supply being added on top of existing supply and the Fed has to balance this tightening pressure with its own rate hikes being applied to the very front end of the curve and from balance sheet run-off. This is bad for bonds and can present a sideways market for stocks even if the broader growth background is strong as it is now. There are roughly $310 trillion worth of financial assets in the world. Of this amount, roughly $90 trillion is in stocks (~30%) and $220 trillion is in bonds (~70%). If there is an inflationary shock somewhere in the developed world, the bond market is going to be hit the most in terms of aggregate value. The least attractive asset in the early phase of the late stage of the business cycle is long-duration, low-coupon, investment grade (IG) or safe debt. There’s not a lot of upside in these until you approach the late phase of the late stage just before the economy enters into recession. Long-duration IG debt is a natural, yield-producing hedge on risk assets, so holding it in some quantity makes sense, but performs poorest during this stage of the cycle. Instead, shorter duration bonds are more appealing and many corporations will use a robust credit market for refinancing their debts if necessary. Even so, credit underwriting has become more careless in the search for extra yield. Banks are underwriting some bad credit – no covenants, cov-lite – and investors are forgoing these traditional forms of protections. Moreover, many financial institutions have a mismatch between their assets, such as high-yield bonds, and liabilities, such as daily liquidity mutual funds, and it’s generally a formula for downside when the economy deteriorates. Bad for the US Dollar Increasing fiscal and current account deficits are bad for the dollar, as funding these shortfalls requires a greater supply of dollars to plug the gap. A weakening currency is inherently inflationary by cheapening exports and increasing the effective cost of imports and weakens the buying power for those holding the currency. In a sense, this is good because a weak dollar is favorable toward asset prices denominated in it. But a weak dollar also produces stimulation to an economy already dealing with stimulation on more than one level – continuing low rates, ongoing QE and zero-bound rates in the EU and Japan, US tax bill, and possibly infrastructure and public-private partnerships bills forthcoming. This creates an additional complication for central banks as it balances any boost in growth with any resultant boost in price pressures as the economy’s operating rates press against output constraints. Good for Commodities and Decent for Stocks In the early part of the late stage of the cycle, you have inflation picking up a bit but not to the point where central banks are tightening monetary policy too sharply. This is good for stocks, bad for long-duration investment grade bonds (as mentioned), and good for commodities. The tightening of monetary policy draws liquidity out of the market, and the resultant environment is less amenable to supporting risk asset prices. Once conditions tighten faster to what’s being priced in, equities will top, and the economy will follow sometime thereafter. We’re still some way from that point. In 2018, the boost to earnings from stronger economic growth will be beneficial and outweigh this tightening, but once growth slows enough, this pickup in rate tightening will outweigh earnings expectations. 2017 was a unique year in the market that was mostly beneficial toward nearly all asset classes. You had growth and earnings pick up, but on net you still had central bank liquidity entering the financial system, leading to a 19% rise in US stocks excluding dividends. But in 2018, while you still have a growth runway, the tightening is becoming more of a factor. That’s why 2018 should be a positive year for equities but not quite to the same extent as last year as the rise in discount rates becomes a drag on the discounting of cash flows. Commodities are the only asset class where prices are still relatively cheap. The chart below shows commodity prices relative to stocks. Currently, they’re at a multi-decade low: Because there was such a large fall in prices from mid-2014 into the early part of 2016, which are still recovering, this impacted investment and supply eventually washed out. Accordingly, you had a large capacity to fill when demand picked back up. Now that economies are growing we’re still in the midst of filling this capacity in global commodity markets. Most portfolios are still underweight commodities as a whole. Commodities nonetheless aren’t a great bet in terms of diversification and don’t carry positive returns expectations over time given they are non-cash producing assets. Given most of them serve as industrial inputs, they correlate positively with equity markets with +0.2 to +0.5 correlation coefficients when averaging them over time. Conclusion In 2018, we’re entering the early part of the late stage of the business cycle where operating rates begin to run into capacity constraints. This remains a decent environment for stocks, poor environment for long-duration safe/IG debt (though holding some is still okay as a hedge against inflation coming in below expectations), bad for the dollar (until the next recession hits when dollar liquidity dries up), and good environment for commodities. In 2015 and into 2016, the markets were pricing in too much tightening into the yield curve, which led to a flat year for asset prices in 2015 and the first ten months of 2016. Now markets are pricing in rate hikes roughly in line with the expectation of the Fed. To start the year, market participants anticipated around 2.2 rate hikes for 2018 relative to 3 for the Fed. That investors’ expectations have now been matched with those of the Fed by drifting upward has produced market jitters throughout February. This should stabilize, though market volatility will remain elevated relative to 2017 as the Fed and ECB – the world’s two most important central banks – begin to reverse their quantitative easing programs and raise interest rates. This drains liquidity from the financial system and is less supportive of asset prices.