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Economic Discussion A Review of the Economy and Financial Markets September 2015 The Economy According to the second estimate (there is one more to come) the U.S. economy grew at an annual rate of 3.7% in the second quarter (1Q) of 2015. First quarter growth was revised upward to 0.6%. The yearover-year change at June 30th was 2.7%. Chart I traces the annualized quarter-over-quarter change for the past 15 years. The red line shows the trend since the Great Recession ended in 2009. The average has been 2.2% and the trend is minimally positive. 5.1% and the Labor Force Participation Rate was unchanged at 62.6%. Chart II shows the path of the unemployment rate over the past 15 years. Chart II The unemployment rate is as low as it has been in over seven years. The participation rate has been steady for the past three months. The level is the lowest in nearly four decades. Chart I On September 4th the Labor Department reported that 173,000 jobs were created in the U.S. in July. The unemployment rate dropped to These data show an economy that is growing at a modest pace. Six years into a recovery, growth of less than 3% is disappointing. Still, most developed economies are doing worse. The United Kingdom is close to the U.S. with 2.6% growth in the last year. The Eurozone and The Review of the Economy and Financial Markets, presented by Chemical Bank, is a publication based on resources such as statistical services and industry communications which we believe to be reliable but are not represented as accurate or complete and therefore cannot be guaranteed. Any opinions expressed in this publication may change at any time without notice. Based upon varying considerations, the management of individual accounts by Chemical Bank may differ from any recommendations herein. This report is provided for informational purposes only and does not constitute a recommendation to purchase or sell any security or commodity. Review of the Economy and Financial Markets September 2015 Japan are growing at less than 2%. Emerging economies, as a whole, are growing at better than 5%. There are substantial differences among them, however. China and India lead the way at 7%. Brazil and Russia are in recessions.1 In recent months there has been concern that China’s growth rate is declining. From 2000 to 2007 the rate of growth was accelerating from about 7% to nearly 15%. The Great Recession knocked it back into the 10% area and more recently it has declined to the current 7% level. The deceleration in Chinese activity has reduced worldwide demand for industrial commodities. As a result commodity based economies have suffered. Economic forecasts that we follow on a regular basis see U.S. growth peaking in the first half of 2016. No one has said so explicitly, but their numbers show that trend. Generally, other developed nations are six months to a year behind the U.S. pattern. As has been noted here, few countries have seriously addressed fiscal issues. They seem content to rely on monetary stimulation to fix economic problems. The result of years of massive monetary expansion is growth at two-thirds the rate of earlier recoveries. In a Wall Street Journal op-ed piece, Holman Jenkins says, “Ben Bernanke (weakly), Mario Draghi (weakly), Janet Yellen (weakly to the point of inaudibleness) have all said monetary policy can’t be the sole fix for the Western World’s slow-growth malaise. Yet their words are unheeded so they settle for being enablers of their fellow elites’ flight from responsibility.” There is little evidence that politicians have the will to undertake necessary fiscal reforms. China is a bit of an enigma. Its economy is planned, i.e. its government controls it. At the same time there is an emerging middle class which demands more economic freedom. The government has allowed a limited amount of free market activity. Allowing a little bit of freedom is like being a little bit pregnant. The government encouraged individuals to own stock. After surging in the first part of 2015 stock prices have fallen 39% since mid-June. Now the government has suppressed any negative commentary on the stock price plunge, according to the Wall Street Journal. Also, economic data releases are government controlled, so even the data we use is somewhat suspect. Global debt has continued to increase in spite of the supposed deleveraging after the Great Recession. According to a McKinsey report total global debt has increased from $142 trillion in 2007 to $199 trillion half way through 2014. In that time it increased from 269% to 286% of GDP. Government debt increased from $33 trillion to $58 trillion.3 Government officials boast that deficits have been reduced. Still, even smaller deficits add to the total debt burden. In the sixth year of this recovery, among the G-7 nations, only Germany has a fiscal surplus! Inflation in most of the world is subdued. Prices in the U.S., the Eurozone and Japan have advanced 0.20% over the last year. The United Kingdom experienced 0.10%. Most of the developing world has seen larger increases. The International Monetary Fund (IMF) estimates 2015 inflation in emerging economies will be 5.5%. (Its estimate for the developed world is 0.0%) Inflation in Brazil, Russia and Argentina are 9.6%, 15.8% and 14.9% respectively.2 It should be remembered that the concept of the modern social state, whether as pure socialism or a mixed economy as in much of Europe and the United States, is less than one hundred years old. We may be witnessing the dénouement of that noble experiment. Globally we are seeing a recovery that is very mature, even though it has not been as robust as historical comparisons indicate it should have been. Inflation is subdued with few exceptions. U.S. growth is likely to be 2.25% in 2015 and 2.60% in 2016. Other developed economies will generally be less. U.S. inflation is likely to be 1.0% to 1.5% for the next two years. Investors will have to continue navigating low-growth economic environments fraught with market dislocations as policy makers “juryrig” fixes. Investors will have to be more flexible and prepared to adjust course than was required in the pre-2000 world. Page 2 Review of the Economy and Financial Markets September 2015 The slide in emerging markets started this past spring. The Shanghai market, representative of Chinese stocks, started its plunge in June. It is now 39% below the peak reached at that time. Developed markets seemed oblivious until August. The S&P 500 is nearly 10% below its early August level. The horrible conflicts in the Middle East and North Africa are exacerbating the economic challenges facing Europe. The news pages are filled with images of throngs of Syrian refugees fleeing for their lives, and some losing them en route. Germany, France and the U.K. are to be commended for their humanitarian approach. Still, we must not underestimate the economic burden posed by the assimilation of such large numbers. Ultimately these immigrants will be able to add economic strength and vitality. In the interim, an already taxed European economy faces yet another headwind. The apparent precipitating factors are China’s decelerating economy and the fear of a rate increase by the Federal Open Market Committee (FOMC). China, although it is clearly a developing economy, has a large effect on the global economy because of its size. At a U.S. dollar value of $10.4 trillion China’s GDP is exceeded only by the U.S. at $17.4 trillion. (If the Eurozone is aggregated its GDP is $13.4 trillion (US).) Decelerating to even the high level of 7% annual growth has a pronounced effect on the rest of the world. Financial Markets and Interest Rates It has been an exciting month for stocks! The following chart shows the paths of the S&P 500 index of domestic stocks (black line), the MSCI EAFE index of developed foreign stocks (red line) and the MSCI Emerging Market index (gray line) over the past year. If the FOMC raises short-term rates at its mid-September meeting, it could be detrimental to stock prices. Central banks cause rates to increase by reducing liquidity in the economy. Generally, liquidity is beneficial to stock prices. Raising rates could strengthen the U.S. dollar. A stronger dollar would have both beneficial and detrimental effects on developing economies. It would help those countries as Americans would have more buying power, some of which would be spent overseas. Debt service by foreign borrowers would become more expensive, however. Also, increased short-term rates would put pressure on domestic companies with weaker-than-average balance sheets. On balance, higher U.S. interest rates are a negative influence on stock prices. As regular readers know, we believe that stock prices are driven, in the long run, by fundamental factors such as earnings and dividend growth. The recent drop in prices has made stocks a better buy for the long run. Foreign stocks show more potential value than domestic issues. The “long run” is emphasized because the short run can seem awfully long when markets are in turmoil. Moreover, stock prices have already taken a big hit. The best strategy now is to reassess asset allocation to Chart III Page 3 Review of the Economy and Financial Markets September 2015 see what effect the price drop has had. (One’s portfolio may already have re-balanced!) Stocks need to be individually assessed. If a company’s earnings stream and dividend flow can withstand an economic slowdown its stock should be retained. Stocks that are dependent on borrowed funding or are sensitive to economic swings should be reviewed as possible sale candidates. Demand for credit is a function of economic activity. In a growing economy, businesses borrow to take advantage of profit opportunities. Individuals borrow for housing and consumption goods. A growing economy gives them confidence to make large purchases. A decelerating economy discourages investment by businesses and purchases by consumers. The foregoing factors exert the greatest influence on short-term interest rates. The current uncertainties are unlikely to be removed in the near future. Investors can be patient. Funds raised from stock sales can be held in cash equivalents until good opportunities present themselves. Inflation tends to raise long-term interest rates because borrowers want to protect the purchasing power of the repayments they will receive. A benign inflation environment, as we are now experiencing, allows longterm rates to remain at a lower level. Bonds present a dilemma. If rates are to be increased, as most believe to be inevitable, prices will fall. Yet, cash equivalents earn almost nothing. The following discussion, on a buff colored background, may provide more detail than some readers desire. If so, you may skip the sidebar. In recent weeks I have been asked often when interest rates will go up. The question is simple. The answer is not. Different factors influence movements in short-term and long-term rates. The question people are asking revolves around an anticipated policy change by the FOMC. The committee is just returning from its annual retreat with other central bankers at Jackson Hole, Wyoming. (Can you imagine going to summer camp with a bunch of central bankers?) The next meeting of the FOMC is September 16-17. It had been widely expected that the overnight bank lending rate would be allowed to increase a quarter of a percentage point. (That’s 25 basis points in bond talk.) Decelerating growth in emerging economies and stock market volatility in recent weeks could cause a delay in the rate increase. Whether the rate is increased in September or when the committee meets in October or December is of little fundamental significance. The timing of the decision may have psychological significance, however. A Yield Curve Discussion In order to understand interest rate movements the factors governing both short- and long-term rates must be considered. A commonly used device is the yield curve. To construct a yield curve rate levels are plotted on the vertical axis and time ‘til maturity on the horizontal axis. The following Chart IV shows yields curves at four different times: currently in black, five years ago in red, ten years ago in gold and fifteen years ago in green. Even the uninitiated will recognize that the earlier two curves represent a different economic environment. They represent a time before the Great Recession and the latter two are following that event. In 2000 and 2005 the U.S. economy was booming and the FOMC was trying to slow things down. They constrained the supply of credit and it caused short-term interest rates to be nearly the same level as longer term rates. In fact, in 2000 short-term rates were higher than longer rates, a phenomenon known as an inverted yield curve. Interest rates are driven by a multiplicity of factors. The supply of and demand for credit have a greater influence on short term interest rates whereas inflation expectations affect long-term rates to a greater extent. The FOMC controls the supply of credit by setting bank reserve requirements and buying and selling securities to or from banks. Page 4 Review of the Economy and Financial Markets September 2015 Supporting heavy borrowers with low interest rates, a highly regulated economy and tax structures that discourage investment also has suppressed the appetite for long term investment. We should get back to the original question: when will interest rates go up? The FOMC will likely increase the fed funds rate 25 basis points before the end of the year. It could happen at any one of the three remaining meetings. Short-term rates will continue to increase through 2016 and beyond. Long-term rates are currently suppressed by economic and political uncertainties. Investors flock to safer investments in the face of uncertainty. A ‘normalized’ level for the current time would be 2.40%. Continued economic improvement, though slow, will carry the ten year yield to 3.00% to 3.25% by the end of 2016. Bonds are a necessary part of a well-constructed portfolio. Even though they return less than stocks, the returns are steadier. Also, bond returns tend to fluctuate out of phase with stocks. (Statisticians would say bond returns are negatively correlated with stock returns.) Investors still want some return. The slope of the yield curve indicates that yield can be increased by investing further out in time. See Chart V. Chart IV A normal curve, if there is such a thing, would show rates increasing consistently as time to maturity increases. In recent years it is easy to understand why short-term rates are low. The FOMC has been flooding the economy with easy credit. The mystery is why long-term rates aren’t higher. The recovery is six years old and it would seem that demand for longer term projects and the attendant financing would be greater. The benchmark ten-year U.S. Treasury note yields 2.19% as this is being written. Early in the summer its yield was 2.40%. Before the Great Recession in mid-2007 it was 5.30%. Since growth returned in 2009 the yield has been as high as 4% and as low as 1.39%. Falling inflation expectations have been a factor, but why is inflation so low? A possible explanation is that the debt level that contributed to the recession has not been reduced. Irving Fisher, a mid-20th century economist, considered debt reduction as a precondition to renewed growth. As noted above, total debt has increased since 2009. Page 5 Review of the Economy and Financial Markets September 2015 9/15/2015 wcl 1 Growth estimates are based on consensus surveys by Bloomberg Finance, LP. Ibidem. 3 “Debt and (Not Much) Deleveraging”, Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mtauchieva, McKinsey Global Institute, February 2015. 2 Chart V The slope is steep to about five years. After that it becomes less so. Individual investors, who generally buy and hold bonds, can increase yield without assuming too much risk by investing in the two-to-five year part of the curve. Active investors like pension funds and endowments could capture higher yield by extending into the seven year range. They will have to trade their bonds opportunistically to get that benefit. In summary, markets have become volatile. The uncertainties are not likely to clear very soon. Stock investors are advised to review their holdings carefully. Those issues with good earnings growth prospects and solid dividends can weather out the storm. Stocks in companies dependent on short-term financing and sensitive to changes in economic activity should be viewed warily. Bonds should be selected in the short to intermediate maturity ranges. Also, credit quality should be high. Issuers of lower quality bonds will be hurt by even modestly higher interest rates. Page 6