• Insights
  • By Jack Ablin
  • February 25, 2018

The Cresset Macroscope

“Defeat is not the worst of failures. Not to have tried is the true failure.” – George Edward Woodberry

Executive Summary

Tax cuts have boosted growth expectations for 2018 but their benefits might not be lasting. For the full year 2017, the economy expanded 2.3 per cent, roughly in line with the 2.2-per cent annual growth rate achieved since the Great Recession – which suggests actual growth is in line with our long-term potential growth rate of about 2 per cent.

Global bond yields are on the rise. At last check, the yield on the 10-year benchmark Treasury note is closing in on 3 per cent; that’s remarkable, considering that as recently as last September it flirted with 2 per cent. The 10-year note’s yield has moved independently of the Fed’s overnight rate. Intermediate-term Treasury yields are more heavily influenced by European bond rates. The February stock market pullback is merely a technical correction and further weakness will be a buying opportunity.

We at Cresset assert that the February pullback was merely technical. Market valuations are expensive and need to correct. At the same time, credit conditions remain robust as the availability of money to borrow, spend and invest is strong.

Strong growth could suck all the spare capacity out of the economy. The US has been on a 3-per cent growth trajectory since Q3/2017. That’s good news, right? Not necessarily. President Trump and his economic team have made it their mission to grow our economy at 3 per cent or more. While this is a noble long-term goal, over the short term the potential growth rate of the US economy is only a little more than 2 per cent with labor force growth of 0.7 per cent and productivity growth of 1.5 per cent.

Private equity secondaries are an effective way for investors to achieve portfolio diversification with lower risk and lower cost. Because secondary buyers purchase more mature pools, there is less exposure to the early years of the investment when funds take their front-loaded fees. Acquiring a fund in a later stage of its life helps reduce expenses and negative returns, particularly if the interest is purchased at a discount to its net asset value (NAV).

 

Economy

4Q/17 growth was solid, but slower. The US economy posted solid, 2.6 per cent, annualized growth over the final three months of 2017. This expansion was fueled by strong consumer spending and a big rebound in home construction. GDP growth fell short of the 3-per cent rate achieved in Q2 and Q3 due to a worse-than-expected trade deficit and slower inventory rebuilding, according to the Commerce Department.

On the one hand, organic growth is a good thing; on the other hand, it’s dull. For the full year 2017, the economy expanded 2.3 per cent, roughly in line with the 2.2-per cent annual growth rate achieved since the Great Recession – which suggests actual growth is in line with our long-term potential growth rate of about 2 per cent. This means the economy is growing organically and not relying on artificial stimulants like debt-based spending. It was the unwinding of debt-based spending in the form of mortgages and home equity credit lines that created artificial economic growth leading to the housing bubble and its ultimate collapse resulting in the financial crisis. The “bad” news about organic growth: it’s slow and boring.

Tax cuts have boosted growth expectations for 2018 but their benefits might not be lasting. Thanks to the $1.5 trillion tax cut signed into law in December, economists are anticipating a stronger economy in 2018. The Trump administration has promised sustained growth rates in excess of 3 per cent in the coming years underpinned by tax cuts, deregulation and tougher trade laws. Sustaining a 3-per cent trajectory would require an upgrade to potential GDP, the combination of labor force growth and productivity. Productivity gains will depend on the ability of tax reductions and other incentives surrounding the tax bill to spur business investment, capital expenditure and R&D. Otherwise, the economic benefits of these deficit-financed tax cuts will short-lived.

Could “business-friendly” end up becoming “beggar-thy-neighbor?” Another knock-on benefit of the US tax cuts could be a globalization of business-friendly policies. President Trump, speaking to the World Economic Forum in Davos, Switzerland in January, declared that “America is open for business.” In a global economy in which the proverbial pie is not growing fast enough to satisfy many developed countries’ hunger for growth, one can get a bigger slice of pie only at the expense of one’s trading partners.  For example, Germany and France, two countries whose all-in corporate tax rates push 30 per cent, feel threatened by President Trump’s corporate red carpet. It is therefore possible that these labor-friendly, red-tape-laden jurisdictions could respond with business-friendly schemes of their own. A global race to the bottom might not be in labor’s best interest, but it could be enormously powerful for global companies and their shareholders.

France could become a showcase for the positive economic impact of labor reform. Europe is enjoying an economic resurgence thanks to a turnaround in France.  Historically one of the least hospitable countries in which to do business, France has become a leading contributor to continental growth: its 1.9 per cent pace of expansion in 2017 was its fastest since 2011. The dramatic labor reforms enacted by President Emmanuel Macron in September have the potential to further propel an already strengthening economy.

 

Bond Market

Global bond yields are on the rise. At last check, the yield on the 10-year benchmark Treasury note is closing in on 3 per cent; that’s remarkable, considering that as recently as last September it flirted with 2 per cent. The 10-year note’s yield has moved independently of the Fed’s overnight rate. Intermediate-term Treasury yields are more heavily influenced by European bond rates. Ten-year German bunds currently yield a scant 0.5 per cent, and were negative as recently as Q4/2016, continuing to support strong demand for relatively higher-yielding Treasuries. While meager European yields are keeping a leash on US bond yields, they are on the rise thanks to strengthening growth and the potential for tighter ECB policies.

Asset allocation will begin to favor bonds over stocks. Higher interest rates have the potential to pressure the equity market in an environment in which stocks have been the only game in town. The fixed-income asset class has been fighting with one arm tied behind its back thanks to quantitative easing. Historically, the yield on the 10-year Treasury note tracked nominal GDP (real economic growth plus inflation). At last reading, nominal GDP is running at around 4 per cent, about 1.3 percentage points above the current benchmark yield. The S&P 500’s earnings yield – the reciprocal of its price-earnings ratio – confirms that view. The S&P 500’s earnings yield had always moved in tandem with the 10-year BBB corporate bond rate. That relationship diverged in 2009 thanks to quantitative easing, and the S&P’s earnings yield is now about 1.5 percentage points higher than the 10-year BBB bond yield (see Exhibit 1).

The unwinding of quantitative easing favors fixed-income investments. The bond market’s yield disadvantage enabled equities to command a premium over the years: this premium was as high as 18 per cent relative to earnings and dividends as of the beginning of January. We expect yields to rise toward fair value as the world’s central banks unwind their quantitative easing programs. The Fed ended quantitative easing in 2014 but has been left holding a massive $4.5 trillion portfolio. The European Central Bank articulated its intention to buy bonds through the end of 2018 while the Bank of Japan has made no promises. All told, the Fed, the ECB and the BoJ collectively hold nearly $15 trillion of securities (mostly bonds) and have injected more than $2 trillion into the financial system over the last 12 months.

 

Stock Market

In my 30-year experience in financial markets I have encountered more equity downturns than I care to remember. Equity pullbacks come in three categories – technical, cyclical and systemic – with varying degrees of severity.

Technical pullbacks, the most benign, are simply corrections. When equity valuations get out of line with fundamentals, like earnings and dividends, prices correct accordingly. Technical pullbacks, while disturbing, are generally short-lived with the bottoming process occurring over a period of days or weeks. Corrections are often spurred by seemingly unrelated news. The blowback is generally isolated to stocks or a few equity sectors. The market’s reaction to the Brexit vote in 2016 was an example of a technical pullback. Due to their sharp and short nature, technical pullbacks are virtually impossible to anticipate and just as impossible to react to quickly enough.

Cyclical downturns are more closely associated with bear markets. As expansions evolve, excess capacity for production and labor tightens, putting upward pressure on prices and wages. Bond investors, anticipating increasingly aggressive monetary policy, push short-term rates above intermediate rates, creating an inverted yield curve. Credit conditions tighten as lenders worry about the creditworthiness of their borrowers and equity prices fall in response to lowered profit forecasts. The bursting of the tech bubble in 2000 marked the beginning of a cyclical downturn in which the S&P 500 shed nearly half of its value between July 2000 and September 2002. Cyclical downturns are easier to spot, take longer to play out and allow agile investors to get out of the way.

Systemic downturns are the most severe of all pullbacks. They represent a general loss of confidence in a country’s financial or political system. This perceived loss of control precipitates a credit contagion and complete loss of liquidity. The Crash of 1929 and the financial crisis of 2008 represent such once-in-a-generation events that were only turned around by extraordinary policy measures. While it took five years for the S&P 500 to recover from the financial crisis, it took more than 15 years to regain the ground lost from the 1929 Crash. Systemic downturns often give off early warning signs: for example, credit conditions tightened in Q4/2007, four quarters before the equity fallout ensued.

We at Cresset assert that the February pullback was merely technical.  Market valuations are expensive and need to correct. At the same time, credit conditions remain robust as the availability of money to borrow, spend and invest is strong. Credit conditions were steady throughout the 1,600-point plunge in early February. While it’s impossible to predict where the markets will meander on a day-to-day basis, we are confident that any pullback that plays out over the next few weeks will represent an opportunity to buy for the long term rather than a reason to sell.

 

Macro Perspectives

Strong growth could suck all the spare capacity out of the economy. The US has been on a 3-per cent growth trajectory since Q3/2017. That’s good news, right? Not necessarily. President Trump and his economic team have made it their mission to grow our economy at 3 per cent or more. While this is a noble long-term goal, over the short term the potential growth rate of the US economy is only a little more than 2 per cent with labor force growth of 0.7 per cent and productivity growth of 1.5 per cent (see Exhibit 2). An economy that grows faster than its potential runs the risk of absorbing excess capacity at a rate that could lead to shortages of labor and production capacity, thereby pushing wages and prices higher. For example, trucking capacity is expected to be tapped out this spring, according to a recent report by industry consulting group FTR Transportation Intelligence.  FTR highlighted its concern that a late winter storm could push capacity utilization over 100 per cent. Shipping rates are spiking.  The national average spot van rate was $2.26/mile in January, up 15 cents compared to December and 59 cents higher than January 2017, a record.

Productivity gains are likely the only way to boost potential growth in the next few years. There are two ways to increase our economy’s potential growth rate to sustain a 3-per cent trajectory without tears. One would be to raise the labor force growth rate, which would require opening our borders and “importing” skilled workers. That strategy is unlikely under current leadership. The other would be to boost productivity – the ability to generate more output with the same number of workers.  Productivity gains require business investment, R&D and innovation. Though business spending has been increasing, productivity gains have been disappointing in recent years.

The economy can simmer a bit longer, but something’s got to give. Short of boosting potential growth, President Trump’s 3-per cent strategy will eventually lead to shortages of certain goods and labor, boosting prices and wages. The bond market and the Federal Reserve will respond, tightening the availability of credit with higher interest rates and slowing the economic cycle. For now, though, we believe there is still a bit more leeway for running the economy “hot.”

 

Investment Strategy

Wealth creation vs wealth preservation: the case for private equity. Private clients hold public securities to preserve their wealth. They hold private equity investments to create their wealth. For most investors, access to private equity is only available through funds in which the vehicle’s sponsor raises investment capital in a blind pool and uses it to make a series of private equity purchases.  Investors make a capital commitment and fund sponsors issue capital calls as they find private equity opportunities. Investment funds typically have a ten-year time horizon prompting sponsors to sell their underlying investments over that timeframe.

Valuation advantage of private investing in funds is offset by lack of transparency, lower returns and timing risk. The biggest advantage that private equity offers investors is valuation. This advantage comes with several costs: transparency, lower returns, and vintage risk. When investors commit capital to blind pools they often do not know in advance what companies their fund sponsor will invest in. Capital commitments aren’t invested right away, leading to lower returns over the entire investment lifecycle. And since all of the fund’s investments are made within a short time period, investors are exposed to timing risk. For example, a pool created in 2006, right before the financial crisis, would likely underperform a pool assembled in 2009.

Private equity secondaries are a better option. Investing in private equity secondaries, a burgeoning market created over the last several years for buying investors’ private equity fund positions in the secondary market, enables buyers of secondaries to avoid many of the pitfalls of an otherwise attractive market. Secondary buyers typically purchase fund interests several years after the creation of the pool, which offers them greater transparency into the pool (see Exhibit 3). That is much more attractive than buying into a blind pool. The timing offers secondary investors visibility into the financial and operating performance of the underlying portfolio companies and, in many cases, underperforming investments have either been marked down or written off.  As a result, secondaries have historically experienced lower loss rates.

Mature pools mean lower fees and, most important, lower risk. Because secondary buyers purchase more mature pools, there is less exposure to the early years of the investment when funds take their front-loaded fees. Acquiring a fund in a later stage of its life helps reduce expenses and negative returns, particularly if the interest is purchased at a discount to its net asset value (NAV). Secondary purchasers might have access to funds they wouldn’t otherwise have seen, either because of missed opportunities during fundraising or because certain managers restrict access to their funds at initial purchase. Since diversification is a concern with sponsored private equity funds, secondary funds are often invested across industries and vintage years, enabling investors to achieve broader exposure to private equity with lower invested amounts. Finally, and most important, secondary private equity funds have lower loss rates than primary funds and have historically delivered lower return variability than their primary counterparts. Secondary private equity could be a good way to dip your toe into an interesting corner of the investment market.

 

Exhibit 1:

 

 

Exhibit 2:

 

Exhibit 3: