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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
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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.
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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
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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.
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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.
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Review of the Economy and Financial Markets
September 2015
9/15/2015
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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.
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