Interviewer: “if you were to be stranded on an island and could have three people join you, who would they be?” (Expecting the answer to include one or more of George Washington, Albert Einstein, Great Grandfather, Barack Obama, Francis Bacon or the Dalai Lama)
Interviewee: “two hula dancers and a coconut chef.”
As shown in the brief interview conversation above, the interviewee decided to answer in a very non-traditional way. Sometimes that alternative thought process is needed. Sometimes it is necessary to open up the discussion by essentially changing the question. Sometimes one needs to go against what is being asked and answer the impossible question in a new way that still makes sense.
We see this opportunity in the current environment when we view the health of the economy debate rage on in conversations and almost everywhere in the financial media. ‘The first quarter of 2014 was soft, pushing out the need to taper.’ ‘The fed’s balance sheet is going to cause hyperinflation given the recent strengthening of the economy.’ ‘The European Central Bank will need to quantitatively ease to prevent deflation.’ Blah, blah, blah. The answers given by pundits remind us of the answers more commonly given to the interview question above when the interviewee attempts to impress by saying “Albert Einstein, Sigmund Freud, and Rosa Parks”. These answers are scripted, educated, complicated, and completely useless.
The true answer to the economic debate is known by all but rarely stated – No One Knows. We really haven’t been here before. There is no script, no play book, and no set of directions.
So, rather than ‘pontificate on the econometric mechanisms both on a macro and micro level that will drive incremental GDP through an inflection in the velocity of the M2 money supply,’ can we actually take a step back, adjust the commentary, and try to find the equivalent of “two hula dancers and a coconut chef”?
What do we really want to know? We want to know how to position assets to best protect and grow purchasing power over the coming years given the uncharted territory in which we find ourselves.
We know employment is improving and history suggests employment moves like a slow train (likely to continue in the same direction at roughly the same pace). We know wages are starting to move up, which has historically led to improvements in consumption. We know banks have excess capital and are willing to lend. We know that businesses are growing their loan demand, which is typically a sign of confidence in future demand. All of this suggests that corporate earnings are not stressed. That’s a good thing.
We can also see that equity valuation multiples are “reasonable” (not particularly expensive nor a bargain). We have seen pockets of exuberance get deflated in the early part of the year, which can be viewed as a healthy adjustment. So the net result of all of this is that equities look ‘fine’ to us. Check the box for one hula dancer.
How about the fixed income markets? We know consumer debt has come down and home affordability is up. We know government debt levels are high, yet rates are low on a 30 year (and even longer) basis. We know that the Federal Reserve is slowly weaning itself off of bond purchases, lowering its impact on setting the prices of government bonds. Corporate credit is showing no signs of stress or distrust among the lenders. So the net result is that rates look really low at a time that government is lessening its artificial demand and the economy is tracking to more strength, arguing that fixed income may be viewed as expensive. That’s the second hula dancer.
And now for the Coconut Chef…
Political instability, European elections, and turf wars in Asia set up discontinuous events that may change the market environment. For now, we know that the political instability is occurring in fringe countries, with little economic influence on global markets. We know that European Union elections will change the makeup of the parliament, but the EU moves at a glacier’s pace no matter who is in place. We also know that the economic linkages within the Asian countries are high, making the likelihood of turf wars escalating a low probability. Accordingly, the takeaway here is that these factors make good headlines, but to this point they will mean little as global economic drivers.
We understand that we risk sounding complacent in this article, which we are not. We are diligently watching indicators that we have found useful in the past and new ones in our attempt to achieve superior performance. At this point, we hear a lot of hot air coming from the market commentators, but not a lot of actual data that would be construed as alarming. Things will change and we stand ready to change our positioning. However, at this point we believe the environment is “steady as she goes”.