For investors looking to position their portfolios for 2017, there is one question that dwarfs all others: Will economic growth and higher interest rates take hold as the new market trend, or can they expect secular stagnation and more of the same sluggish, grinding forward for the global economy?
The stakes are high here because the investments that would perform best in each scenario are so wildly different. Resource-related stocks, for instance, would underperform badly in slow growth environment, but generate big returns if the U.S. and global economies accelerated. Perhaps more importantly, the extremely popular income-generating sectors that have done well in recent years would likely see dramatic weakness with an inflationary market backdrop.
Merrill Lynch chief investment strategist Michael Hartnett is among the most strident believers in a higher growth, higher inflation environment. In his Oct. 5 report, "Peak Liquidity + Peak Globalization + Peak Inequality = Big Rotation," Mr. Hartnett writes that "positioning, policy and profits" will deliver a 2016-17 "flip" from deflation to inflation, from zero interest rate policy winners to zero interest rate policy losers. Mr. Hartnett recommends investments in commodities, small cap stocks, collectibles and U.S. real estate.
Importantly, the zero interest rate policy "winners" that Mr. Hartnett believes will underperform include the income-oriented market sectors that have dominated Canadian investment portfolios since the financial crisis – bonds, real estate investment trusts, utilities, and other high yielding instruments. Merrill Lynch is focusing on U.S. markets, but historically Canada has imported higher yields and inflation from south of the border, and the trends in U.S. markets quickly affect domestic assets.
The boldness of Mr. Hartnett's predictions has been supported by bond yields and the relative performance of cyclical and defensive stocks. The chart below, reproduced from Citi Research, shows that cyclical, economically sensitive U.S. stocks have been outperforming defensive sectors like consumer staples in recent weeks. The strength in cyclical sectors, shown here by the rising Vanda cyclicals versus defensives U.S. index (notwithstanding a slight dip last week), has coincided with a rise in 10-year U.S Treasury yields.
Mr. Hartnett's inflationary, rising growth forecasts are far from the consensus view. The majority of prominent economists expect growth to remain anemic, with dividend and income stocks continuing to outperform. Citi's Mark Schofield and Willem Buiter recently wrote, "Weak growth, sluggish trade, limited policy options and the ongoing search for returns in an ultra-low rate world are powerful themes."
UBS global macro strategist Themos Fiotakis wrote a giant tome of a research report entitled "Secular Stagnation and Equities: the New Normal" in which he writes, "[T]here is evidence that trend growth may have slowed [post-financial crisis]. Low inflation expectations indicate that disinflationary forces are likely to persist … evidence indicates that lower nominal GDP growth is likely to ultimately result in lower earnings growth too."
Our chart suggests that the more growth, inflationary views of Merrill Lynch are in ascendance at the moment, but the sustainability of the trend is still an open question. There have been numerous economic head fakes in the past five years where it looked like growth was set to pick up, only to see the trend fade. We also have the expected Federal Reserve interest rate hike to deal with in December.
I mentioned that stakes were high for investors in terms of portfolio performance, but an immediate re-allocation of investments is, in most cases, unnecessary. Investors will have time to follow the trends and adjust accordingly. In the short term, investors who are hugely overweight income investments should consider taking some profits; diversification – in terms of carefully chosen, cyclical stocks – makes sense for a small percentage of total portfolio assets in case the inflationary scenario fully takes hold.