Since we view the economy as the key driver of the market's direction, we spend a great deal of time assessing it, keeping in mind the cyclical nature of economic and market events. During the downturn, we began to position our portfolios for an economic rebound, due to leading economic indicators that made it clear to us that the recovery was ahead; as the recovery unfolded, we heightened exposure to riskier (but not speculative) assets as the market enjoyed the bounce. Now, we see the market beginning to enter a more mature growth phase, one that offers less dramatic spikes than those coming off of a trough but which we believe can be sustained for an extended period of vigorous growth.
Bolstered by continued business spending and consumer spending that is being supported by wage gains, the economy is growing at a healthy clip. Given this environment, it is only natural that the Fed has recognized that the economy can begin to move forward on its own momentum and has allowed interest rates to begin their rise from 46-year lows back to more normal levels. Indeed, if the economy was not demonstrating its staying power, the rate rises would not be initiated. Current inflation rates are well within the normal historical range, and in line with a growing economy. As rates return to more neutral range, we anticipate that the economy will continue to do what it is doing: post solid productivity numbers, accelerate top-line growth, and prompt additional spending and hiring.
Within this backdrop, we believe that corporate earnings will still remain strong and supportive of further gains, but will slow in comparison to the recent rapid surge during the earlier phase of the recovery. We also look forward to other constructive steps taken by businesses, such as an increase in M&A activity as a means to right-size industries with excess capacity. Also, we foresee an increase in equity offerings, as the cost of capital falls for both equity and equity-linked securities (such as convertibles and high yield bonds). The cost of capital should be stable for fixed income, as fiscal policy will remain stimulative.
Prospects for growth appear attractive, as return on capital is increasing and already at levels above the trailing 40-year average. At the same time, cost of capital is flat to falling and growth in capital is improving. Even so, the current market appears only fairly valued, with no remarkable excess in regards to security valuations: this leads us to believe that the opportunity set for security selection remains large, and our research efforts continue to glean attractive names.
Looking abroad, Japan continues to improve, with increases in industrial production and economic activity, strong exports, and the country's fastest growing GDP in 13 years. China is a net positive for the global economy, as inflation looks to be low and profits appear to be strong, driving export opportunities for other countries to new highs. With that said, we anticipate that the US dollar may experience a measured drop as other economies climb aboard the economic growth track. As a result, our trade deficit may need to be financed with slightly higher interest rates for the buyers of US debt.
Although the geopolitical environment provides much to worry about, in reality, this is nothing new. Diversification, risk management, and our longtime experience of witnessing numerous markets' climbing walls of worry allow us to invest past such concerns. Similarly, while the upcoming presidential election may ultimately have a large influence on fiscal policy, an impact of this sort-if it even occurs-would be a few years off and potentially mitigated by Congress. In the end, it is simply too early to know and too close to call; the market is--at best--neutral on the potential impact at this point in the election year.
Given our outlook, we believe our clients will be well served by our maintaining the long term asset allocation we have discussed for numerous quarters: We continue to emphasize equity sensitive and equity linked securities, mid-grade debt, and avoid the interest-rate sensitivity of low risk bonds. As the more stable phase of the economic cycle continues to emerge, we will continue to modestly adjust portfolios to favor less cyclical names, companies with higher quality balance sheets, and more stable, free-cash-flow generators. As always, such portfolio adjustments remain tied to our fine-tuning of risk/reward profiles across strategies.