Macro Winds A-Blowin’: What It Means For Investors In 2018

2017 has been an exciting year in the markets. All-time highs seem to fall every week, the market has shaken off three Federal Reserve rate hikes as no big deal, and there is so much bitcoin to talk about that it makes a head spin.

It’s also been an exciting year on the Seeking Alpha Marketplace. Marketplace is our platform for authors to offer investing services that go beyond what they can do in public articles. In 2017, we went from 75 authors on the platform to 155. Those authors have a wide range of expertise and backgrounds. And while 2017 has felt like a year where everything has gone in one direction – up – we wanted to draw on this diverse array of backgrounds.

So, we’re doing a Year End Marketplace Roundtable series. Over the next 2 weeks or so, we will be featuring expert panels giving their outlook on 2018 in corners of the market ranging from Tech to Energy, Dividends to Alternative Strategies, Gold to Value investing. We hope you’ll find these discussions useful no matter how you invest.

Let’s get to it. Introducing our panel:

Eric Basmajian, author of EPB Macro Research

Eric Parnell, CFA, author of The Universal

John Lohr, author of The Fiduciary Sale

Reason Investments, author of Better Retirement Investing

Tom Luongo, author of Stocks, Shocks & Rocks

Seeking Alpha: 2016 was viewed as a big year in geopolitics – the U.S. election, Brexit, etc. Did 2017 strike you as a change in direction from recent years, or a continuation of trends, and how so?

Eric Basmajian: I think that each year there are external factors such as geopolitics that have varying impacts on the market. The past two years may have been more volatile as it pertains to headline news, but the markets around the world have risen and fallen based on their fundamentals rather than geopolitical news as they always do, so in that regard, I believe it is a continuation of trends. The problem with geopolitical news is that it is challenging to quantify and the investment decisions derived from the geopolitical news are often based on speculation, fear, and bias. I try to only make decisions quantitatively, using tangible economic data, so geopolitics has never really influenced my economic outlook.

John Lohr: Trends are trends. Sometimes they are quietly seething and sometimes they respond to a catalyst and erupt. What we see in politics, social issues, economic and financial trends as we end 2017 represents a complacent majority and a very vocal minority stirring the pot, making it allowable to vent unpopular conventions.

Tom Luongo: 2017 was a continuation of the trends set in motion by the big events of 2016. In Europe, we saw more examples of the underlying causes for the Brexit vote – Catalonia Independence, Germany rejecting Merkel, Austria moving against immigration. In the U.S., we saw wholesale opposition by the entrenched political establishment to everything Donald Trump wanted to achieve.

These events laid bare the fundamental division between the needs of the political class in the West and those of the people. And it’s leading to big political and economic consequences starting this year.

At the same time, China and Russia secured the futures of its major central Asian partners, namely Iran and Turkey, through deft diplomacy by both Russian President Vladimir Putin and Chinese Premier Xi Jinping.

China’s Belt and Road Initiative Summit was attended by the leadership of more than three-fourths of the planet, with only Western Europe and the U.S. sending undersecretaries and third stringers. It was something that was overlooked by so many people and it screams that the world wants a different order than the one that’s been in place since the end of the Soviet Union.

EB: Interest rates have come up, but only on the short end of the curve. The two-year treasury rate is around 1.8% compared to 0.94% two years ago, but the 30-year treasury rate is around 2.7% compared to 3.0% two years prior. The rise in short-term rates and falling of long-term rates, or “curve flattening” is a very strong leading indicator of weaker economic growth. I believe that the short-end of the treasury curve will continue to rise if the Federal Reserve continues to raise rates and the 30-year treasury rate will continue to fall. The treasury curve flattening will bring slower economic growth in 2018 compared to 2017.

EP: Corporate earnings growth is set to continue improving into 2018. How much that translates into a more sustained and broadly based economic growth environment remains to be seen, but it bodes well for risk asset prices including stocks at least in the near term. Monetary policy is set to tighten measurably in 2018, including rising short-term interest rates, and as liquidity conditions shift, the potential for a reaction in risk asset prices in the form of increased volatility both to the downside as well as the upside will likely rise. So while the forces of growth may lead in the short term, the forces of rising interest rates are likely to be more felt in the intermediate term to long term.

JL: Growth can’t continue, but interest rates will inch up for several years. Supply side economics has proven not to work. Big business and tax cuts for the wealthy in 1925, 1986, 1997 and 2003 were systematically followed in five years by a significant recession. The slow bleed of our biggest buyers of Treasury issues, like China, will force rates to continue to climb, albeit slowly.

Reason Investments: We expect economic growth to be more persistent than interest rate increases, but that is because we believe central banks have little room to raise short-term rates without risking an inverted yield curve. Long-term government bond yields likely will remain anchored by a lack of inflation and we have no reason to believe that long-term real interest rates will rise absent a major change in global savings/investment dynamics. Our best guess as to why long-term real rates remain stubbornly low is the very high savings rates in developing markets, especially China, and that factor likely won’t change in 2018.

The U.S. equity market boomed thanks, in part, to the efforts to undermine Trump and the commensurate weakening of the U.S. dollar throughout 2017. Now, the dollar has bottomed, the euro has topped and the Fed is raising rates to stem the tide.

The Fed will continue to raise rates for two reasons. One, because it doesn’t want to be blamed for another stock market bubble like in 1999, even though conditions are completely different. And, two, because fixed income funds are starving for yield after a decade of QE and back-door bailouts of the banking system.

I see both rising rates and rising growth in the U.S. in 2018. Trump’s tax plan will have an immediate effect thanks to it accelerating capital inflow to the U.S., which will be put to work at lower costs-of-capital. The Fed will respond to a rising market with higher rates. The U.S. dollar will soar.

Obviously, rising rates and a rising dollar will cut growth down at some point. But, given the size and scope of the capital flight I expect to see out of Europe beginning this year, they may not be enough. 2018 should be a good year for Trump, politically.

SA: Where in the world or the markets are you focused on as a potential safe haven and/or outperformer in 2018?

EB: With stock market valuations stretched to record levels around the globe, I continue to view long-duration US treasury bonds as the safest investment. I think the bond value is safe due to weak growth and inflation that has been causing long-term interest rates to decline over the past several years. The United States has a very dire financial situation, but relative to the other major developed countries, the United States is the safest. Europe, China, and Japan all have debt burdens far more massive than the United States, which should serve to keep a bid under the US Dollar and the value of the bond. I wrote about this at length in my article, “The Federal Reserve Has Never Printed Money: The End Game.”

JL: There are no safe havens.

RI: We continue to favor foreign developed equity markets in 2018, particularly those sectors that are more economically sensitive. We believe such stocks offer more return potential than similar companies in the U.S., even after adjusting for the greater risk of Europe’s banking sector.

TL: The United States, for all the reasons I stated above. U.S. markets are the ones deep enough, and now, friendly enough, to take in the capital fleeing Europe. Russia will do well because it has also positioned itself to be a receiver of capital inflow as Europe retrogrades and its banking system reflects the instability of its political system.

But, Russia can take on 1% of the capital that the U.S. can, but that will be enough for Russian markets to perform very well in 2018, like they did in 2017.

SA: What was the big story or lesson learned for you in 2017?

EB: Markets can act irrational for longer periods than you may expect. I continue to learn that it is increasingly important to have a decision making process that is based on a consistent set of principles. Having a decision making process that is rules based can be put into simple algorithms that can make decisions without emotion. Most mistakes that investors make come from over trading (trading too frequently) and trading from emotion (fear, bias, narrative). When markets are stretched to extreme levels, it can be increasingly difficult to avoid letting emotion impact your decision making, and that has been challenging in 2017. A rules-based approach to investing can help investors avoid these mistakes. EPB Macro Research continually updates the decision making process by adding new rules and principles to govern the portfolio construction process, attempting to eliminate as much human-error as possible for the purpose of maximizing total return over time.

JL: I understand better than ever that investors as a rule are undereducated as to investment processes and investment planning. Performance and the “deal of the day” still motivate buyers, and the “buy at the top” herd mentality is still prevalent. Investors and their advisors need relevant, unbiased, non-product motivated financial and investment education, information and advice now more than ever.

TL: The political elites will distort every market to achieve their goals. 2017 was the year of propping up the EU to keep Merkel in power. The strong euro was a counter-trend rally within a primary bear market that was helped along by a massive campaign to de-legitimize the U.S. president.

Regime uncertainty is always reflected in the foreign exchange markets.

The other big lesson is that if you control one safe-haven market, gold, to the point of it being irrelevant, something else will take its place. And that’s the reason for the massive bull market in the cryptocurrencies, a la Bitcoin.

SA: What are you preparing for in 2018? Any big themes to watch out for?

EB: My current forecast is that the Federal Reserve is going to reverse the course of monetary policy before the end of 2018 due to severe disinflation and anemic or even recessionary levels of growth brought on by excessive debt and that the equity market will experience a much choppier ride due to these factors. The Federal Reserve is likely to cut interest rates or stop the sale of assets by the end of 2018 due to falling long-term rates that will cause a very flat or inverted yield curve. The flat yield curve will continue to hurt the banking sector and cause loan growth and therefore money supply growth to contract. The contraction of the money supply will reduce nominal economic growth. I believe in 2018, due to these factors, investor sentiment will change from optimistic and greedy to one of more caution and fear of a pending economic slowdown.

A big theme to watch out for is the slowdown in growth and inflation that causes the Federal Reserve to reverse monetary policy at the end of 2018.

EP: The 2018 calendar year is setting up to be a transitional year. Corporate earnings momentum and policy induced liquidity remains strong heading into the year, which should help support risk asset prices in the early part of the year. But the liquidity spigots are set to be slowly turned off as the year progresses, and this assumes underlying inflationary pressures remain benign. As a result, arguably the most important theme to watch in 2018 is the potential rise in volatility as the year progresses and global capital markets slowly awaken from what has been a near decade-long policy-induced dream state. How much policymakers stand by during any associated tremors along the way will be just as notable.

JL: We launched a 501(c)(3) public charity, The MoneyCulture Initiative, to provide financial and investment education, information and advice to the general public for free. We firmly believe that a movement such as ours will gain significant momentum in 2018 as the investment world reels, discouraged from a confluence of financial disappointments: a market correction first quarter 2018 after the corporate tax cut euphoria dies, a flat to slightly down equity market during the year, disappointment with economic and tax policies, and the ultimate crash of Bitcoin.

RI: Many stocks may be vulnerable to disappointment following the reduction in the U.S. corporate income tax rate. Too many pundits and analysts are raising earnings targets under the assumption that nearly all of the tax savings will fall to the bottom line or be used for investment. The reality of competition for most companies ensures that the real winners will be customers, in the form of lower prices for most services and goods. The potential dis-inflationary impact of new corporate tax policy bears watching over the next few years and may provide another reason for the Federal Reserve to be cautious in moving toward a more neutral monetary policy.

We will reach an interim peak in Bitcoin (possibly unfolding now) and will see a big correction. That will likely light a fire under gold as a natural rotation trade occurs and people rebalance their safe-haven asset allocations.

I’m looking ahead at the Italian Elections in May as well as monitoring German coalition talks. Poland and the rest of the Visegráds are on a collision course with Brussels. There are so many flashpoints for the EU any one of them could trigger a major banking collapse.

I’m also preparing for continued U.S. equity growth, again, as a form of safe-haven trade. This is why the U.S. yield curve is flattening. Central banks have been loading up on U.S. treasuries to arm themselves against a much stronger dollar.

Lastly, I expect Bitcoin will continue its meteoric rise on any hint of financial instability, regardless of taxing authority threats. If you always remember that capital flows to where it is treated best then you have a pretty good idea of what’s happening at the macro level.

Trump is winning. His opposition is losing. Merkel is doubling down on dissent. Capital is coming to the U.S. and leaving Europe. Since those are two of the biggest markets in the world, that’s the dominant factor and everything else stems from that.