“Goldilocks….Slow Mo”

There used to be a phrase commonly used by economists and market analysts when discussing the economy which you don’t hear much anymore. The phrase was the “goldilocks economy”. It meant that the economy was growing at a reasonably good pace, enough to support rising corporate earnings, without generating high inflation and, therefore, was “not too hot and not too cold”, but “just right” to keep the stock market happy. That was back in times when “normal” economic growth was something like 3-4% real GDP, like we had in the 80s and 90s.

 Today, we have a “new normal”, which is slow (1-2%) growth, slow job creation, slow consumption, and low inflation…..and what one could describe as a “goldilocks economy” in slow motion, which appears to be just fine with investors, thank you, as the stock market moves to record highs. Why are investors happy? In this case, it is primarily because slow growth is causing the global central banks to maintain a highly accommodative monetary policy. In fact, today (April 29), it appears the European Central Bank may be prepared to lower interest rates. This on top of what we expect will be continued highly accommodative policy stance on the part of the U.S. Federal Reserve.

The market likes this “goldilocks economy” because the “easy money” policies appear to have no end in sight. The idea is excess liquidity pumped into the financial system by the central banks will find its way into the stock market, with the U.S. right now being the market of choice for most global investors. This has favored, and continues to favor, large-cap dividend –paying stocks which are highly sought-after in the current environment of very low interest rates. Bond yields have become so low, that fixed income investors have been seeking higher returns in higher yielding blue chip stocks. This “reallocation” of assets has changed the investment risk paradigm and actually increases financial system risk, as stocks are inherently more volatile than bonds.

The good news is the “new goldilocks” economy appears to be doing reasonably well, albeit still at a slow pace. Within this backdrop, we don’t see the new “risk paradigm” changing much in the near term, which is positive for stocks. From a financial planning perspective, one of the best ways to protect against higher systematic risk is through diversification: holding a portfolio that includes a number of asset classes that are not highly correlated. While this will result in growth that may be slightly below that of the stock market when stocks are rising, it protects the portfolio through reduced downside risk when stocks are declining and should result in higher risk-adjusted returns over the long term.

 

2.5% is really “that bad” ?

So the “concern du jour” is lower than expected 1Q GDP growth: 2.5% instead of the expected 3%.  As usual, we see a lot of quotes this morning from so-called “experts” conjuring up new concerns about slowing growth to wit: "There are some concerns as we head into the summer," said JJ Kinahan, chief derivatives strategist for TD Ameritrade. "In the last three weeks, we've have seen numbers that weren't exactly what you'd love to see."  C’mon. The economy showed decent improvement in Q1 over Q4 (+0.4%) despite a drag from a decline in government spending, which is estimated to have cut Q1 GDP growth by 0.8%. It was also encouraging to note that consumer spending was the strongest in over two years. That’s important because consumer spending is over two-thirds of the economy. And while hiring remains slow, business spending remains relatively healthy. Point is, the improvement in Q1 GDP is a positive but the tone of this recovery has not changed: it will continue to be a slow, grinding recovery. In the meantime, the private sector continues to do OK. Corporate earnings and cash flow continue to improve, providing a positive backdrop for stocks. In fact, analysts actually raised their forecasts for 2Q earnings growth from 1.5% to 3.6%. From a financial planning perspective, we believe a normal allocation to equities is warranted with some of our favored sectors being real estate, health care, and large-caps.

Summary of Our Recent Investment Strategy Meeting

We held our second quarter investment strategy meeting on March 28, 2013. Despite the market achieving record levels recently, we remain constructive on the outlook for equities for a number of reasons. We expect the economy to continue to grow with the potential for some acceleration later this year and in 2014. Continued economic growth should support further growth in corporate profits and cash flows, which are key drivers for stocks. We expect inflation to remain relatively low, particularly near term, and with a continued accommodative Federal Reserve policy, we also expect interest rates to remain relatively low. Valuations, while increased, are not yet at levels that would cause us to be overly concerned. We also believe investor sentiment, reflected in continued apathy and disbelief, remains constructive.

We now view the stock market as reasonably valued but not overvalued. We believe the enormous amounts of cash sitting in corporate coffers provides considerable “fuel” to ramp up M&A activity, which would be positive for stock valuations. We see similarities in the current market with that of the late 1970s and early 1980s period. During that period towards the end of that secular bear market, corporate cash flows became grossly undervalued. This eventually resulted in a wave of mergers and LBOs that preceded the secular bull market of 1982-2000. We think many of the same conditions exist now: lot’s of corporate cash, many businesses still undervalued relative to sustainable cash flow.

With regard to fixed income, we are keeping an eye on the possibility that interest rates could begin to rise more sharply. Interest rates, as reflected in the 10-year Treasury, actually bottomed in late July and have risen modestly since then, perhaps presaging an improving economy or an end to Fed easing. Given the rather modest growth of the economy, as of now, we suspect any increase in rates will continue to be moderate and not of a jarring or rapid increase that could upset the stock market. We are watching the trends in interest rates carefully as a rapid rise in rates would have potentially negative ramifications for both stocks and bonds.

In terms of changes to our allocation model following the meeting, we increased our allocation to equities slightly, while reducing exposure to fixed income. The increases in our equity allocations were primarily in large cap equities, mid-cap growth stocks, and natural resources. Within large cap equities, we added a new investment in the health care sector. We believe this sector offers strong secular growth prospects and believe it deserves some added emphasis in client portfolios. Our reduction in fixed income exposure was primarily centered in intermediate-term holdings, primarily intermediate-term TIPS.