CAPITAL MARKETS OUTLOOK To summarize, as an economic cycle ages, inflation rises as demand outpaces supply. As a result, the central bank increases interest rates, thus lowering demand relative to supply. At an inflection point, demand is lowered by enough relative to supply that monetary velocity slows, excess capacity exists, and a contraction begins. In advance of the onset of a contraction, the central bank has lifted short-term interest rates above long-term yields (which represent the market’s price of money given projected inflation rates), thus inverting the yield curve. Since this has not happened yet, we believe there remains time in this secular bull market; however, just as importantly, investors should now expect periods of selloff and consolidation. This is not unheard of historically, with two notable examples in 1984 and 1994, as noted earlier. In both years, we saw market corrections when the Federal Reserve had not yet gone past the point of no return. Given the relatively uniform move higher in U.S. equity markets since 2009, investors may not be prepared to deal with the ramifications and are likely to view volatility as a sign of the beginning of a bear market resembling the last two bear markets. History, however, is chock full of examples of sharp equity market declines without recession. Again, while these can be painful in the short-term, they are healthy for the market longer-term. Since the bottom in March 2009, only Thai stocks have outperformed U.S. equities, and it is unlikely there were many investors shrewd or bold enough to allocate a majority of their portfolio to Southeast Asian securities. Our takeaways are: 1) the gap between the economy and equities has been larger than in previous cycles, and 2) diversification of any kind outside of U.S. equities has led to underperformance. The latter’s impact on the hedge fund community over the past 10 years is illustrated in Figure 6. Quite simply, diversification has failed on the back of overzealous central bank policy which disproportionately affected U.S. equities at the expense of other asset classes. This has led not only to a gross underperformance in the hedge fund community, but among active managers in general. As can be seen in Figure 7, if we look at the percentage of active managers outperforming their benchmarks, it is surely no coincidence there is a large drop-off concurrent with central bank policy following the global financial crisis.
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