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Climbing the Wall of Worry Among Mid-Year Optimism

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Summer has been heating up the news cycle. Trade headlines dominate; midterm elections are impending; interest rates are on the rise; a strong second quarter stokes conversations about peak growth.

The takeaway is clear: there are a lot of disconcerting issues for investors.

There is something to this conversation. A late-cycle economic environment is one in which investors should gradually prepare for managing risk. The low-hanging fruits of growth have been picked; the supply of available labor gradually becomes scarcer; wages rise at an increasing rate; debt financing becomes more costly; and corporate profits face downward pressure.

Economic downturns cannot be avoided, and timing the markets is very difficult. That said, we remain constructive in 2018 and into 2019, and believe that the balance of positives outweighs the negatives for portfolio positioning. Within this context, we have identified seven key risks to the U.S. macroeconomic environment that contribute to investor hesitance heading into the end of the year – seven bricks in a wall of worry. Our macroeconomic view debunks each of these concerns. This turns market participant hesitation into a positive opportunity, as markets historically climb the wall of worry.

Related: Multi-Factor ETFs: Adding the “Free Lunch” to Factor Investing

Seven bricks in a wall of worry:

  1. An inverted yield curve is historically known to predict recessions. However, we do not yet have an inverted yield curve – only a flattening one – and even an inverted curve can be a long-dated predictor.
  2. Rising interest rates impact fixed-income markets and could slow consumer and business gains. For now, the Fed’s normalization policies are healthy.
  3. Inflation is not a meaningful problem for the U.S. economy at this time.
  4. Our research shows that the months leading up to a midterm election are generally supportive of equity markets.
  5. Trade tensions could intensify before they abate, but we do not expect a bad scenario, or at least not one that lasts for long.
  6. Earnings have not peaked, but earnings growth may have. We are focusing on fundamentals to identify how we can optimize a potential style-factor return shift.
  7. The risk/reward trade-off in credit is not particularly attractive to our team, but it does not signal an impending crisis.

On balance, the critical economic data suggests that things are just fine for financial markets. The macroeconomic environment is strong; labor markets are tightening; credit conditions appear frothy but have not yet worsened. This is good news for investors and presents opportunities for upsides. We are focused on five pieces of critical data to “climb” the wall of worry:

  1. Fiscal stimulus, such as tax cuts and government spending, are rapidly boosting economic activity, and are likely to last at least another year.
  2. We expect to see an acceleration in capital expenditures (CAPEX) by year end.
  3. The Trump Administration has shown a willingness both to loosen regulations and to lessen the enforcement of rules in some circumstances, creating opportunities for sector plays.
  4. A tightening labor force and rising wages contribute to discretionary income, boosting economic growth.
  5. Technological advancement keeps a lid on inflation directly by creating new low-cost distribution methods (e-commerce, fracking, Uber, etc.), and indirectly through unit labor costs.

In the coming weeks my team will expand upon these concerns and opportunities, focusing on their potential role in our asset allocation process.

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