In September, we continued with our Stagnation Outlook for the twelve-month forward period. The global economy continues to chug along with the July IMF forecast for global economic growth of 3.5% for 2017 and 3.6% for 2018 looking attainable¹. All 46 countries monitored by the OECD are on a growth track this year for the first time since 2007².
Rising geopolitical risks including North Korean nuclear tests and American hurricanes have contributed to short-term offsets to this optimism. At his Jackson Hole address in late August, European Central Bank President Mario Draghi told the audience that U.S. protectionist policies also pose a serious risk for growth in the global economy.
Global central bank asset purchases, which have totaled almost $2 trillion this year alone, are the best explanation for money flowing into both bonds and stocks. Shifts in growth and central bank policies are likely to sustain flows away from the U.S. dollar and toward the euro and emerging market currencies. The dollar had acquired a premium in late 2014 and 2015 as it became clear that the Fed would be first to engage in tightening policy. At the same time, political turmoil in the Eurozone helped drive investors into U.S. assets in search of higher yields and better growth. The anticipated lower economic growth in the U.S. will not be enough to keep those flows while growth in Europe and emerging markets are much better.
Federal Reserve officials are reviewing their most basic inflation models. Minutes from the July FOMC meeting showed a revealing debate over why the economy isn’t producing more inflation in a time of easy financial conditions, tight labor markets and solid economic growth. The central bank has missed its 2% price goal for most of the past five years.
Sustained loosening of financial conditions is unique to this tightening campaign, driven in large part by persistently strong equity market returns and a weakening dollar. This behavior has confounded markets and Fed officials. Further tightening is coming as the Fed will soon start shrinking its balance sheet. Since 2008, the Fed has been buying assets resulting in about $2.5 trillion of Treasury bonds and $1.8 trillion in mortgage-backed securities on the balance sheet³. The Fed does not plan to sell these assets; however, as the securities mature, it will stop reinvesting the proceeds, with the permitted monthly run-off gradually rising. U.S. 30-year bonds are most impacted by tightening but the lack of inflation coupled with credit contraction creates a scenario of further flattening of the U.S. Treasury yield curve.
During August, investors nervous about North Korea and other geopolitical risks favored the relative safety of bonds, pushing bond yields lower and prices higher. Long duration government and agency bonds outperformed in that environment, while short duration securities underperformed. August results for U.S. Treasuries posted positive returns, as yields tightened across the entire curve. The S&P 500 gained 0.3% in August, outperforming S&P MidCap 400 (down 1.5%) and S&P SmallCap 600 (down 2.5%). Outside the United States, Canadian equities were positive with the S&P/TSX Composite up 0.7%, while the S&P Developed Ex-U.S. BMI was flat and S&P Emerging BMI gained 3%.
In September, we revised our asset allocation in the Conservative and Moderate Growth models while maintaining the Growth and Aggressive Growth models. The changes reflect our view that we will continue to see a flattening of the U.S. yield curve and an opportunity in the long end of the yield curve. In both Conservative and Moderate Growth, we eliminated U.S. Mid-Caps and added to long U.S. Treasuries. In Moderate Growth, we also added a portion to the S&P 500.
We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.
Deborah Frame, President and CIO
¹IMF. World Economic Outlook. July 23, 2017.
²BCA Research. Global Investment Strategy. Fourth Quarter 2017: Goldilocks And The Recession Bear. October 4, 2017.
³Federalreserve.gov. Quarterly Report on Federal Reserve Balance Sheet Developments. July 26, 2017.
Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. August 31, 2017. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros.