Chief Investment Officer

50 Chief Investment Officer / December 2017
and a weakening US dollar appear only to have heightened investors’
appetite for these stocks over the summer.”
Meanwhile, the theme of global growth has worked against
domestically focused cyclical stocks.

“By contrast, the performance of small-cap value stocks in
the US, which tend to be more cyclical and more geared to the US
domestic economy, had lagged large-cap growth stocks by almost
20 percentage points by the beginning of September,” Knutzen
asserted. “This is just the most extreme expression of the general lack
of favor shown to the more cyclical parts of the economy.”
The lack of inflationary pressures mounting despite strong
global growth is another key puzzle of the new market environment.

“Despite the synchronized growth cycle, the summer months
saw inflation go missing in action across many of the world’s econo-
mies,” Knutzen wrote. “In the US, consumer prices started to disap-
point in March and wage inflation has flatlined for a year.”
On the structural side, technology and demographics are seen
as major deflationary forces. The competition and price pressures
technology introduces are seen as rising costs. And a retiring popula-
tion is seen as spending less, while creating demand for fixed-income
assets that keep bond prices in check.

“Federal Reserve Chair Janet Yellen has expressed puzzlement,
unable to decide whether this was a result of short-term effects or
something structural, such as the rise of online shopping or the baby-
boomer cohort entering retirement,” Knutzen wrote, and the Fed
has consequently pushed out its schedule for interest rate hikes. This
led to a cascade effect, with markets further discounting the pros-
pect of rate hikes. “September saw Federal Open Market Committee
(FOMC) members lower their ‘dot plot’ forecasts for the path of
interest rates. But where the FOMC was merely hesitant, the market
reacted strongly, lowering its estimate for the pace of 2018 hikes and,
For all the vexing about the lack of inflation in the new market
backdrop, though, Knutzen argues that inflationary pressures are
not structurally different, but just lagging.

“Our view is that we are currently moving from mid-cycle to
late-cycle growth, which implies that some rise in inflation ought to
be baked into expectations,” Knutzen wrote. “Against a background
of synchronized growth, low and falling unemployment, and US
corporate margins at record highs, we believe the current softness
in inflation could be a lagged effect of weak growth and low energy
prices during 2015-2016.”
The unduly disinflationary expectations subsequently create
opportunities for investors, and more recent market actions show
that initial perceptions could be changing.

September saw more inflationary expectations creeping into
the market as “the US dollar and crude oil rallied, yields rose,
energy and financial stocks were bid up, and rates markets pared
back much of their skepticism about a December hike from the
Fed,” Knutzen wrote. “But we believe that pricing still lags the
potential, especially in key indicators such as US inflation break-
even rates. As such, in a scenario of a return to a moderate rise in
inflation, the Fed’s forecast for rate hikes in 2018 would be closer to
reality than the markets.”
Whether and when inflation materializes, and gauging the role
it will play, will be central to the new market environment and a
break for the deflationary conditions of the last decade.

As the global economy demonstrates robust growth, meanwhile, central banks have begun to unwind their positions. And this means that investors must rethink paradigms from the post-financial crisis era, including the active versus passive debate, with the latter having made enormous strides in a high-correlation, low-dispersion era.

“Fueled by extraordinary global central bank intervention, equity markets have soared since their 2009 trough, leading to conditions unsupportive of traditional capitalism and active management, including high levels of correlation and low levels of dispersion,” Joseph Amato, Peter D’Onofrio, and Alessandra Rago from Neuberger Berman wrote in an October research report. “Stock correlations within the S&P 500, for example, have spiked nearly 20% since May 2009, depriving active managers of the opportunity to distinguish winners from losers through fundamental research. Post-crisis market conditions also suggest that the past decade is not an ideal timeframe Sep’97Oct’98Oct’99Oct’00Oct’01Oct’02Oct’03Oct’04Oct’05Oct’06Oct’07Oct08Oct’09Oct’10Oct’11Oct’12Oct’13Oct’14Oct’15Oct’16Oct’ 17