Fall Forward

Fall began last week here in the US, even thought the weather seemed like summer and so did the performance of financial markets. The case for a continuation of strong 1H performance laid out in these pages last June ( 2nd Half Outlook: More of the Same Please June, 2017) has played out with a global 60-40 portfolio returning roughly 3% for the quarter and close to 10% ytd.  The question for today is what’s in store for Q4?

Much will depend on the ability of the best global synchronized economic recovery in decades to offset the onset of quantitative tightening (QT) as Central Banks, led by the Fed, begin to row back some of their easy money policies. There is no shortage of additional concerns: US tax reform potential, the US – North Korea standoff, building Gov. pressure on Big Tech and political uncertainty in Europe and Asia. Climbing the proverbial wall of worry has been a hallmark of this bull market as has low volatility begetting low volatility. Will it continue? My short answer is yes.

Lets utilize the Tri Polar World (TPW) regional framework to consider these various concerns, most of which fall under the four categories of our Global Risk Nexus (GRN): economics, politics, policy and markets. As always we will end up with some portfolio strategy and asset allocation thoughts.


The Fall calendar for the US is absolutely jam packed: the onset of the Fed balance sheet reduction, tax reform, the North Korea standoff, NAFTA negotiations, Big Tech & the Russia investigations to just name a few.

The US represents the front line for the potential trade off between tightening monetary policy and fiscal stimulus as the Fed begins its balance sheet reduction process amidst the Trump Admin’s tax reform/stimulus rollout. A trade off between reduced Central Bank largesse & fiscal stimulus seems like a good one, especially given the underlying support of a solid global economy. To wit, if not now, when?

The Fed has clearly delineated its plans and financial markets have responded with appropriate calmness, pricing in a December rate hike and the start of balance sheet reduction later this month. The USD has stabilized, interest rates have risen and stocks have taken it all in stride.

Fiscal stimulus seems likely to be a 2018 event given scant details and a short legislative calendar prior to year-end. Deficit hawks have morphed into pigeons, suggesting significant potential for tax cuts to provide a late cycle boost to an ageing US economic recovery. This boost may well also support other late cycle economic activity like cap ex spending and rising M&A activity.

Big Tech has become a big issue for legislators around the globe. Privacy concerns, Russian spy worries, wealth concentration and monopoly fears have combined to put a target on the back of the biggest sector in global equities. Calls for more taxation, regulation and company spending to prevent such abuses from reoccurring are in the air.

How this plays out remains to be seen but two points are warranted. First, big tech in the cross hairs of Gov. is not a US only concern; Europe, under Competition Director Margrethe Vestager, is carving out a role as tech regulator (maybe because it lacks big tech champions) while China’s big tech companies are running into Gov. pressure across a range of fronts including being compelled to buy minority stakes in poorly performing SOEs. Second, tech’s weight in various stock indexes around the globe means investors really need to start paying attention.

Two other issues bear observation. First is the North Korea standoff where two men who rarely hear the word “no” confront each other. President Trump has already made it very clear he does not like to be told what to do or say. His nemesis, Kim Jong-Un, is a 33 yr. old dictator who disposes of those who tell him no. Pres. Trump’s upcoming China trip, perhaps in late November, may offer the best chance for some type of negotiated settlement.

Ongoing NAFTA negotiations also bear watching.  Three rounds of talks have concluded with very little visible progress. Timing here is also very tight given the electoral calendar in both Mexico and the US.  Financial market reaction has been muted to date but this is an important area to observe, especially for Mexican equity holders (2017 Global Outlook: America First? Dec. 2016). Hopes for a breakthrough extension of NAFTA to encompass all of South & Central America did not even make it on the table, reaffirming the Americas“Inactive” title in the Tri Polar World narrative.


Just when one thinks the all clear signal can be given for European politics the Germans, yes the Germans, spring an election outcome surprise. Chancellor Merkel is returned for a 4th term but with diminished power, the far right (AfD Party) enters the Bundestag and coalition building, always a struggle (av time = 90 days), will likely include the Greens and FDP (the so called Jamaica coalition). The good news is the potential for more domestic spending offset by possibly reduced maneuvering room on EU integration.

Thus talk of French President Macron moving from EU integration junior partner to leader as Chancellor Merkel focuses on the home front. Time will tell; Macron has been quite vocal while Merkel continues to see deeper European integration as her legacy. The integration message is at some odds with what is happening in Spain where the Catalan independence referendum vote was marred by some heavy-handed police tactics. This too will take some time to decipher with Madrid and the EU saying the referendum was illegal and Catalan passions inflamed by the police response. It is interesting to note that while 90% of those who voted, voted yes to independence, only 42% of those eligible to vote did so. 

EU integration does seem to be moving ahead at the corporate level. M&A activity in the steel sector with Thyssenkrupp – Tata and in rails with Siemens - Alstom suggest EU corporates understand the need to develop European heavyweights to protect regional market share and gain global heft. Further such cross border/intra regional M&A activity is likely in the financial sector among others.

Europe’s robust economic recovery coupled with an expectation that the ECB will move quite slowly in reversing its current momentary policy mix supports a positive outlook. As the economic recovery deepens, with manufacturing PMIs at 6-year highs, bond yields have also started to move higher, reflecting better growth. Equities have taken the yield back up in stride, recognizing it as confirming a robust economic recovery rather than as a threat to the economy.

Viewed through the GRN lens, Europe gets high marks for its economics, a slight mark down in its politics, continued solid grades in its policy settings and an appealing set up in financial markets.


Between Japan’s snap election and China’s long awaited Fall Party Congress, politics are likely to be front & center in Asia as well. As in Europe, solid economics provide a benign backdrop. Policy outcomes, especially in China, could impact markets. All of the above provides more grist for the GRN mill.

Opposition party disarray among the new Party of Hope suggests the October 22nd snap election is PM Abe’s to lose.  Abe has sweetened the pot with an $18B fiscal package. Market concerns are likely to revolve around BOJ leadership where rumors are swirling about Gov. Kuroda’s longevity. Given Japan’s robust economy and confidence (as expressed in the BOJ’s Tankan survey) at a decade high, the election is unlikely to cause great changes in the economy or financial markets.

China’s Party Congress could well be a different story with significant policy shifts likely to materialize in its aftermath. One area to watch closely is in the financial sector particularly around the issue of capital flows. Given stable FX reserves and currency, there could be a real opportunity to loosen restrictions on public market inflows and outflows, helping to deepen and broaden China’s growing financial markets.

A key tenet of the Tri Polar World is each region’s growing ability to self finance; the recent success of a $7B USD bond offering by China Postal Savings Bank illustrates Asia’s growing ability with 97% of the take-up from regional investors.

The coming five years will likely witness the rising weight of Chinese companies in non Chinese portfolios and concurrently the rising importance of non China holdings in China based portfolios. ETFs are likely to be the preferred vehicle for these flows as Asian and European capital markets catch up to the US in terms of ETF activity levels.


The third quarter continued where the first half of the year left off with the only bad decision was to not be invested. How long this state of affairs lasts is anyone’s guess but the thesis that low volatility begets low volatility and above average returns (as discussed in 2H Outlook) has held true with September recording the lowest volatility for the month in almost 50 years (1970). Where does opportunity lie for the remainder of the year?


Seasonality offers a near term guidepost. Upon entering Fall, equity markets exit the year’s worst seasonal period. Different market technicians have different end dates for this seasonal period of woe but most agree it ends by mid October at the latest. S&P 500 strength during this historically poor return period is leading market technicians to forecast 5%+ returns in Q4. This seems high but would be in line with the returns suggested by the low volatility studies noted above. Dips are likely to be shallow and should be bought.

Over the medium term, fiscal policy could provide further support, boosting earnings. Year /year US real earnings growth is running at 13% versus the historical average of under 2%.  Q3 forecasts are for 6% y/y EPS growth in the US, which suggests a low bar. Outside the US, earnings have been quite strong and are expected to remain so given the synchronized nature of the global economy. In addition the very gradual nature of equity market appreciation means that few parts of the market look extended.

Broadly speaking equity continues to be favored over fixed income and non US DM equity over US equity. Hedged Japan equity (DXJ) is favored over Europe and within Europe regional exposure (EZU) is favored over single country exposure. Spain (EWP), Europe’s fastest growing major economy and a favored market, has sold off and is now oversold for most conditions minus a full split.

On a sectoral basis, the tech sector is worrisome given its precarious political position around the globe.  IT has been THE leadership sector and now represents 23% of the S&P and an astounding 27% of EM equity (EEM).  Interestingly, tech’s weighting in Japan (13%) and Europe (8%) is much less and represents another reason why one would want to overweight the non US DM equity. Q4 represents a good opportunity to take profits in tech.

Big Tech risk suggests finding potential new leaders could be very profitable. The US Industrials (XLI) sector remains a top prospect with its bellwether GE (single largest position) looking to make an important bottom. A cap ex boom, fueled by tax reform and symptomatic of late cycle economic activity, could well propel Industrials forward through out the Fall.

US small caps are also appealing (Peering Thru the Mist, Aug. 2017). IWM was up roughly 8% in September after trailing all year. Industrials, small caps and financials could all serve as leadership this Fall and offer attractive risk – reward profiles given their lack of performance for most of the year.

Outside of the US, Japan and Europe continue to look appealing with hedged Japan equity (DXJ) breaking out of its 2017 trading range. Japan’s appealing mix of attractive valuation, very strong earnings growth and improved corporate governance could spur inflows (foreign investors have been large sellers ytd) especially if political worries cap enthusiasm for Europe. 

Japan looks set for several years of good economic experience as record low unemployment leads to wage gains and improved consumption. The PGS view that 2017 could represent the year of inflation in Japan suggests potential corporate pricing power, something not seen for some time.  Risk – reward looks compelling.

European equity has moved in fits and starts this year amidst a better than expected economic performance. As The Economist laid out post the German elections one can either be a pessimist or an optimist on Europe; I remain a steadfast optimist and believe the upside for European investments remains quite significant. Solid economic growth, a fairly valued Euro, continued ECB policies and strong earnings growth all support equity prices. Financials(EUFN) remain the most attractive sector in a rising rate environment.

In EM equity the focus remains on China (MCHI) which benefits from sizable tech exposure (a main beneficiary if investors choose to move away from US tech) as well as banks set to benefit from relaxed PBOC cash reserve rules. Tech and financials combine to equal 63% of MCHI. Mexico exposure remains intact (EWW) though concerns are likely to grow as we approach the 2018 electoral cycle.


On the fixed income side the story remains much the same with credit more appealing than sovereign and USD exposure preferred versus non-dollar. Specific positions such as financial preferreds (PGF), High Yield (HYG) and USD EM debt (EMB) remain quite compelling. There are tons of reports suggesting fixed income is in even more of a bubble than equities supposedly are – a good piece of MSCI research caught my eye lately which analyzed 40 years of data and concluded that US equity and fixed income were only “moderately expensive”. 

That seems right to me; the Fed may want to raise ST rates but will be limited by lack of supply and continued strong demand for long duration safe assets offered by the long end of the UST curve. Yield curve inversion is not something the Fed is likely to want to manufacture.


Commodities represent an area of new interest following last month’s small cap discussion. Heretofore the focus has been on gold/silver (GLD/SLV) for defensive purposes. It now looks like the broad commodity sector could be setting up for a good move. Here’s why: China’s economy has stabilized, major segments (oil, industrial metals) are approaching better supply – demand balances, multiple commodity hedge funds are closing, CTAs have gone net short and the charts look pretty compelling. As a portfolio diversifier and inflation hedge the space deserves some consideration with a multi commodity ETF (DBC) likely to work best.

Well, one could write all day but its Fall & that means apple picking season… enjoy the fresh fruit!