The Secular Outlook

Our uniqueness and commonality with the Euro Zone and Japan place us in an interesting spot in the short and long-run.


On one hand, we are different than the Euro Zone in that our Central Bank has not pushed interest rates into negative territory which:

  1. Would hurt our banking system
  2. Would keep zombie companies alive at the expense of healthy ones
  3. Would create speculation into more risky assets

On the other hand, we are like Japan in that our populations have aged and population growth has slowed significantly.

Population Growth

Aging like Japan comes at an economic cost. Every year, a dwindling pool of working-age people is forced to support an expanding pool of gray-haired consumers. This is the main reason Japan’s living standards have fallen behind rich older populations.

When older populations’ natural rate of interest is below interest rates then deflation occurs. With the natural rate tied to a country’s future overall growth rate, many economists believe that low population growth rates make it harder for central banks to ward off deflation. With Japan, their population growth has turned negative and they have slipped into deflation because of the pandemic.

Japan’s export-reliant economy is in recession, with three straight quarters of contraction through June, as the outbreak slammed business activity and stifled trade.

The Euro Zone is in bad shape also. Not only has the pandemic decimated short-term growth; deflation is now setting in, raising the risk of a prolonged contraction. 

The latest Brookings-Financial Times Tracking Indexes for the Global Economic Recovery (TIGER) update shows, many economies are experiencing essentially no growth, or are even contracting. With private-sector confidence depleted, and the struggle to contain the virus far from over, the risks of substantial and long-lasting economic scarring are on the rise.

In the US, the increase in long-term unemployment, together with ongoing service-sector disruptions, will make a sustained recovery harder.

What can the Fed do?

The Fed has only one option: to restrain economic activity by reducing reserves and raising rates. They are not capable of stimulating economic activity to any significant degree. There is the risk currently that the Fed has already overshot the Effective Lower Bound (the level where lowering rates further is counterproductive) as that rate is somewhat above zero.   

As the Fed has said stimulus must come from the fiscal side and fiscal strategies must come with comprehensive plans to manage the new pandemic wave. Without such strategies, demand and confidence will disappear.

“This did not start as a financial crisis but it is morphing into a major economic crisis, with very serious financial consequences,” World Bank Chief Economist Carmen Reinhart told Bloomberg Television last week. “There’s a long road ahead.”

Secular Outlook – Asset Classes & Mixes

Uncharted Territory: In the last 40 years never before have we seen stocks so concentrated in such a handful. The five largest stocks in the S&P 500 have a combined market cap that equals that of the ‘smallest’ 389 stocks.

There has also never been such a disconnect from prices and the economy where the correlation has turned negative.

Here are the expectations for various asset mixes.

Asset Mix 5 offers the best return/risk profile with the highest Sharpe. This is especially true if there is an expectation of deflation.

The return on stocks is based on the 10 year expected return utilizing the current Shiller CAPE. The current CAPE value of 31.69 places it in the 96th percentile.

The return on bonds is the current yield on a 10 Year Treasury.

Risk numbers are historical annualized standard deviation.

The Risk-Free rate is the current yield on the 90 day T-bill.

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