All Eyes on the Fed

Now that the Federal Reserve’s asset purchase program is coming to an end, the focus of financial markets is shifting quickly to the Fed’s policy in 2015. Members of the Fed have already announced their intention to raise short term interest rates as soon as they are convinced the economy has achieved sufficient strength and momentum to weather such a rate hike. A lively debate has begun within and outside the Fed as to when the interest rate normalization process should commence, how aggressively it will proceed, and what impact this will have on the U.S. economy and financial markets.

What is at stake is the continuation of the five year economic expansion and stock bull market. Pessimists argue that early and aggressive rate increases would break the U.S. economy, possibly foment a recession, and cause a significant stock market retreat. Other Fed watchers are concerned with the opposite outcome; the Fed will proceed too slowly and cautiously, thereby permitting a buildup of inflation and the formation of asset bubbles. Optimists, on the other hand, have confidence that the Fed can lift rates gradually to a long-term norm without disrupting the economy and the stock market. Marietta falls into the latter camp in our response to the key questions of the debate:

1. When do we expect the Fed to begin raising rates?

Members of the Fed itself disagree on an appropriate start date. Kansas City Fed President Esther George has stated that the U.S. economy is already strong enough to withstand higher interest rates. Conversely, Charles Evans, Chicago Fed President, thinks that economic conditions will not be suitable until at least 2017. The key viewpoint will almost surely be that of Fed Chair Janet Yellen, who has expressed that a probable date would be six months following the end of tapering, but with the assumption that the economy would continue to strengthen into 2015. We consider April 2015 to be the most probable start date. This is based on our six month forecast for GDP of approximately 3%, inflation below 2%, and unemployment below 6%. During this period we expect a growing consensus within the Fed supporting Chair Yellen’s prediction that economic circumstances would justify taking action at that time.

2. How aggressive do we expect the Fed to be in implementing rate increases? 

We expect that economic growth will be strong enough and inflation sufficiently tame to support a gradual increase in the Federal Funds Rate to about 1% by the end of 2015. This prediction assumes that the Fed will want to be cautious and, if necessary, err on the side of being too slow rather than being too aggressive. We consider Chair Yellen to be especially dovish. This pace would also be consistent with precedent: in each of the last three rate raising periods following recession and accommodative low rates (1984, 1994, 2004), the Fed started with a .25% rate raise and proceeded cautiously.

3. What is the likely consequence for the U.S. bond market?

We expect the yield on the benchmark 10-year U.S. Treasury to rise from its current 2.5% yield to 3% or slightly above by the end of 2015. This modest rise would be consistent with the two most recent periods (1994, 2004) when prior Fed policy normalizations started. We think such an increase in the benchmark yield would be consistent with approximately 3% GDP growth and the perception that the Fed was proceeding with caution. Nevertheless, this rise in yields would probably result in a slightly negative total return from now through 2015 for many bond mutual funds.

4. What is the outlook for the U.S. stock market? 

From now until April 2015, as the debate over Fed policy becomes more feverish, market volatility will probably increase. We think the market will hold and possibly advance into year-end based on continued strength in the economy and corporate profits. Further, investors will be reluctant to take gains, and performance oriented hedge funds will feel pressure to achieve competitive performance. A correction, however, becomes more likely in early 2015. As the first rate hike approaches, anxiety could cause market weakness. In subsequent months, additional rate hikes could intensify economic uncertainty and exacerbate a market downturn. Nevertheless, we think that by the end of 2015 the market will recover and hit new highs as it becomes increasingly apparent that the economy has not been damaged and corporate profits continue to rise.

A historical perspective supports our outlook. J.P. Morgan has examined the last six Fed policy normalizations and has drawn attention to two observations. The first is that there was a clear market weakness averaging -4% over the three to four months following the first rate increase.  The second is that in five of the six occasions, the stock market made a new cyclical high within twelve months. We agree with their conclusion that “any potential dip due to policy uncertainty should be bought into.”

Although some investors will greet the next phase of the economic cycle with apprehension, we consider a normalization of rates to be healthy. We emphasize that our views are based on certain assumptions, one of which is an absence of a surprise geopolitical development that significantly alters economic and market forecasts. We consequently think that it is especially important to remain vigilant and flexible in what could well prove to be challenging conditions ahead.

Federal Reserve Supports Marietta's Positive Outlook for U.S. Economy and Stock Market

On March 21, the Federal Reserve Open Market Committee reiterated its positive year-end forecast for U.S. economic growth in 2014 and 2015. In a subsequent press conference, Fed Chair Janet Yellen stated that weak U.S. economic data in January and February was due primarily to bad weather and would pick up in coming months. She emphasized that "the Committee's views are largely unchanged" since December and confirmed the Fed's prior prediction of 2.8-3.0% GDP growth and 1.5-1.6% inflation in 2014. With this promising outlook, the Fed expects to continue its tapering policy to completion in September. It will proceed to raise its base short-term interest rate after a pause if inflation and employment data continue favorably.

Marietta's January 3 Outlook emphasized the importance of economic acceleration and corporate profit growth in extending the 5-year bull market through 2014. The 29.6% surge in the S&P 500 index in 2013 was driven in part by a 10.8% increase in S&P 500 corporate earnings but even more by an increase in the market's P/E valuation. This "multiple expansion" has resulted in a rise in the Index's current P/E ratio on trailing 12-month earnings to 16.5, which is above the last 10-year average of 14.7 We consider the market to be fully valued rather than overvalued, but we think a further advance should be fueled by earnings growth rather than multiple expansion. Hence, our bullish view relies on our favorable 2014 forecast of 3.0% GDP growth and a rise of 7-9% in corporate earnings.

We are encouraged by the 4th quarter corporate earnings reports released during the 1st quarter. According to Howard Silverblatt at Standard & Poor's, 64% of S&P 500 companies reported earnings above Wall Street estimates and an additional 11% met expectations. He also indicates that company research analysts are currently estimating an increase of 12.1% in aggregate operating profits for all of 2014. Assuming the S&P 500's P/E valuation remains constant through 2014, this increase in profits would reward investors with another year of double-digit returns. We think this scenario is reasonable because the market's valuation multiple is unlikely to contract as long as the expected return on money-market funds and bond alternatives remain unattractive.

A concern for some investors is that the Fed's statement is actually negative for the stock market because it hastens the date of an increase in historically low 0-0.25% short-term interest rates. We are not persuaded. The Fed has clearly indicated that it will not raise rates until it is convinced that economic growth has achieved healthy, sustainable growth, which in turn will increase investor confidence in further profit growth. Our view is that investors will not become excessively alarmed as long as inflation and interest rates remain below long-term norms of 2% and 4% respectively.

Global Economy Slowing Again, but Accelerating Growth Coming

In each of the last 3 years, the global economy started the year with a burst of momentum, lifting global stock markets.  In each of these years the U.S. and international economies subsequently hit a spring and summer “soft patch” resulting in double digit declines for global market benchmarks.  Building evidence that the leading economies of the world are once again experiencing a “soft patch” has understandably created concerns that another sharp correction in equity markets may be imminent.  A correction is always possible, especially following the hefty gains registered since last September.  Nevertheless, we confirm the view in our April 3 Outlook that this economic “soft patch” will likely be short and shallow, and that markets will enjoy strong rallies as the year progresses (as in each of the past 3 years).  We are reducing modestly Marietta’s 2013 global GDP forecast from 4.0% to 3.7% to adjust for the current slowdown, but maintaining our outlook of 4.5% in 2014.  We also anticipate a further advance in global stock markets next year as economic growth accelerates.     

Evidence of a developing global economic slowdown is widespread, although the deterioration seems less troublesome than in past years.  In the U.S., employment data shows that in March employers added the fewest workers in 9 months.  March retail sales suffered their biggest drop since June 2012.  Regional manufacturing reports also reveal disturbing trends.  First quarter GDP growth of 2.5% came in below consensus expectations of 3.0%.  The situation in Europe is more worrisome:  auto sales are disappointing, manufacturing is weakening, construction is slumping, and unemployment has risen to a new high.  Some of the stronger economies, such as France, are teetering on the brink of recession, and the slump in the peripheral countries of Greece, Portugal, Italy, and Spain is deepening.  Even the fast-growing, leading emerging economies are exhibiting problems.  Disappointing GDP and manufacturing data in China have again kindled fears of a hard landing (see our 12/24/12 blog Chinese Economy and Stock Market Rebounding).  In Brazil, sliding consumer confidence and rising inflation and interest rates have prompted economists to scale back their growth estimates for the year.  Commodities are a good measure of the pulse of the global economy, and they have been sliding since February.    

The causes of the current “soft patch” vary from country to country.  In Europe, the Cyprus debt crisis and continuing political and economic uncertainty in Italy, Spain, and Greece are causal factors, but the primary culprits are the government austerity programs.  We attribute the slowdown in China to the bumpy progress of the government in shifting the focus of economic growth from exports and infrastructure to consumer spending.  The U.S. slump is attributed to a variety of causes, although it must be noted that there are economists who claim that the statistics are based on faulty seasonal adjustments and there is, in reality, no “soft patch.”   We think the slowdown is real, and we blame it primarily on the expiration of the payroll tax cut and the higher income taxes on affluent Americans.  In combination, they will cost taxpayers some $150 billion this year.  The government’s sequester, which kicked in on March 1 and will cut spending by about $85 billion this year, is also a brake on growth.  Any discussion of the ebbing strength the U.S. economy must include the lack of business confidence.  Businesses are sitting on record piles of cash ($1.8 trillion in U.S. corporations listed on the major stock exchanges) and are evidently too uncertain about the future economy to invest in new plants and/or employees.  In our view, political gridlock in Washington, federal fiscal irresponsibility, and excessive regulation all contribute to this reluctance to invest in the future.      

Our positive forecast, then, is based on a future improvement in the confidence and optimism of business in the leading economies.  This is the role of the policymakers, and we think they will respond appropriately.  The major supports for future global growth are the world’s central banks, which are moving decisively forward with accommodative policies.  International Strategy and Investment (ISI) has counted 379 stimulative policy initiatives around the world over the past 20 months.  More is coming.  A decline in global inflation, in part a beneficial byproduct of the decline in commodity prices, is providing central banks, particularly in the U.S., Europe, and China, with a green light to proceed.  The Federal Reserve has stated repeatedly its determination to keep rates low until unemployment, now slightly below 8%, drops to at least 6.5%, and on May 1 indicated its willingness to increase its pro-growth activities if the economy falters.  The most recent convert to a pro-growth policy is the European Central Bank (ECB), who cut interest rates on May 2 in response to a drop in inflation below 2.0% and a rise in unemployment above 12%.  The next central bank to join the parade may be India.  The Economist (April 6, p. 14) summarized the synchronized recovery program:  “The message from the rich world’s central banks is clear:  the era of ultra-loose monetary policy is here to stay.”  The full impact of these unprecedented stimulus measures, which typically takes 6 months or more to have full effect, is unclear but, in our opinion, is decisive.  

Recent developments in Japan are instructive.  Prime Minister Shinzo Abe has urged the Bank of Japan (BOJ) to combat decades of deflation by engaging in monetary easing designed to raise inflation to at least 2%.  The BOJ has responded, and the key consequence has been a dramatic decline of the yen, which in turn has increased significantly the competitiveness of Japanese exports.  In a different economic environment, Japan would be condemned as a currency manipulator.  In today’s growth threatened world, however, the International Monetary Fund, the World Bank, and the G20 leading economic countries have expressed support for the BOJ.  At home, the Japanese stock market has surged, consumer confidence is at a 6 year high, retail sales are rising, exports are rebounding, and Abe’s approval rating has soared to a record 76%.  Politicians and central banks around the world are taking notes.

Politicians in the U.S., Europe, and other countries are jumping off their austerity platforms and onto the growth bandwagon.  Partisan bickering over taxes and budget deficits among U.S. politicians has cooled and compromise to limit the negative consequences of sequester is increasingly in vogue.  In Europe, the severe and immediate austerity policy championed by Germany has come under attack.  The views expressed by The Economist are gaining adherents:  “In Europe the combination of a timid ECB, harsh austerity and minimal structural reforms is not giving growth much of a chance” (April 6, p. 16). 

We are not depending on the policy makers alone to lift the U.S. economy.  In addition to the quantitative easing activities of the Fed, the strengthening housing market and the rising stock market are bolstering growth.  The rise in residential real estate prices, which in February increased year-over-year by the most since May 2006, is especially encouraging.  Housing lifts employment, consumer net worth, and consumer and business confidence.  The same is true of rising stock prices.  In combination this “wealth effect” helps account for last month’s jump in consumer confidence.  Most investors believe the stock market is itself a forward indicator of the economy’s future, and today the S&P 500 Index closed at an all-time high with a gain of 12% since the beginning of the year.  Clearly, investors are not overly worried.

Assessing recent trends and developments, the IMF in April released its updated Overviewof the World Economic Outlook, which we consider positive and supportive.  Although the IMF reduced its global 2013 GDP projection from 3.5% to 3.3%, they left in place their 4.0% estimate for 2014.  All of the key economies, including the U.S., Euro-Area, Japan, China, India, and Brazil, are expected to achieve higher growth next year than this year.   In particular, U.S. growth is forecast to rise to 3.0% and China to 8.2%.  Even Italy and Spain are expected to emerge from recession.  We detect a note of relief at the IMF.  Looking back on 2012, they began their report: “Activity has stabilized in advanced economies and has picked up in emerging market and developing economies, supported by policies and renewed confidence.” 

In each of the past 4 years we have posted a blog regarding the then current “soft patch,” and in each case we predicted (correctly) an economic and market recovery.  We again counsel investors to exercise patience and remain cautiously optimistic.

Clouds Gathering on the U.S. and International Economic Horizon

There is a growing consensus among economists that the U.S. economy is slowing, and this revised outlook is being reflected in the stock and bond markets. A late April survey taken by the National Association of Business Economists, released on May 16, projected 2011 U.S. GDP growth of 2.8%, down from their early February forecast of 3.3%. The slowdown, first evidenced in disappointing 1st quarter GDP growth of only 1.8%, was also featured in The Economist’s recent cover article “What’s Wrong With America’s Economy” (April 30-May 6).

The reduced outlook for the U.S. economy comes at a time when doubts are also spreading regarding the strength of the international economies. In Europe the sovereign debt crisis has reached an ominous level: the austerity programs crafted by desperate governments in Greece and Spain are encountering increasingly belligerent popular resistance, and the policy makers at the European Central Bank (ECB), the International Monetary Fund (IMF) and leading Euro-area governments (notably Germany) have become more divided and intransigent in their failed effort to agree upon a remedy. Crippled by the economic consequences of the earthquake/tsunami/nuclear catastrophe, Japan has again retreated into recession. Within the leading emerging economies of China, India, and Brazil, intensifying inflation has forced governments and central banks to adopt ever stronger restrictive measures, which in turn has led to heightened investor fears of “hard landings.” In this perfect storm of economic concern, the Economic Cycle Research Institute (ECRI), a widely watched barometer of trends with an exemplary track record, issued on May 19 a statement that “there’s a downturn in global industrial growth in clear sight,” but added that they saw no sign of a renewed recession.

The response of global financial markets has been swift, and arguably excessive. Investors have suddenly turned cautious. In the midst of a flight to safety, the yield on 10-year U.S. Treasury notes plummeted from 3.59% in mid April to 3.13% on May 23. The U.S. dollar reversed a 4-month slide and in a three week period stretching from April 29 through May 23 rose 4.3% against a basket of currencies. On the other side of the coin, the prices of economy-sensitive commodities, which had soared for a year with only minor interruption, crashed: during this same three-week period, the CRB Index of agricultural and industrial commodities plunged -9.1%. Also damaged in this period were the international stock markets. As volatility rose to unnerving levels, the iShares MSCI ETF of developed countries (EFA) slumped -6.9% and the iShares MSCI ETF of emerging economies (EEM) sank a chilling -7.8%. The Standard & Poor’s 500 Index fared better with a more modest decline of -3.4%, but within the U.S. market there was a seismic rotation. Out of favor were many of the economy-sensitive, high-growth, low dividend, small and mid cap stocks that had led the market since the beginning of the bull market in March of 2009. Elevated to favor were many of the recession resistant, slow growing, high dividend, and previously underperforming mega cap stocks. Out were energy, materials, industrials, and information-technology stocks; in were health care, consumer staples, and utilities stocks.

If the recent economic developments and financial market trends persist and strengthen they will present a challenge to the consensus (and our) global economic outlook and investment strategy. Have we reached a point where it is necessary to alter our view of a healthy, if geographically unbalanced, multi-year global economic expansion extending through at least 2012 and abandon the growth-oriented equity strategies that have served us so well the past two years? At this point, we do not think so. The highest probable scenario, in our view, is that the global economy will experience a “soft patch” and choppy stock markets followed by a resumption of 4-4.5% economic growth fueling further market gains. We note that “soft patches” are a normal phenomenon of past economic cycles, and it would be very unusual for a cycle to last only two years.

It is not possible, at this juncture, to predict with conviction the severity or duration of a “soft patch,” but the prospect of a double-dip recession is quite low. There are many positive developments buttressing economic growth. The employment picture continues to improve gradually, consumer spending is resilient, corporate profits and balance sheets are very strong, interest rates are very low, exports are robust, financial institutions continue to strengthen and are more willing to lend, etc. Very important is that the outlook for inflation, which has been a major factor in igniting economic and market fears, is significantly improved by the recent sharp decline in commodity prices. Since the end of April through May 23, when the CRB Index retreated -9.1%, the price of crude oil dropped -14.2%. We expect a summer pick up in U.S. consumer confidence as gasoline prices fall, and relief from rising food and energy prices in the emerging economies may permit policy makers to back away from policies designed to slow their economies. The global equity strategy group at Citigroup on May 19 observed that the commodity price pullback indicates that a peak in inflation and interest rates is imminent in the key emerging economies of China, India, and Brazil, and predicted a 31% rise in emerging economy equities by the end of 2011.

Like the economy, there are also positive conditions supporting the U.S. stock market. Strong corporate profits continue to provide attractive valuations despite the large stock gains of the past two years. In addition, huge corporate cash positions should result in higher dividends, a pick up in stock buyback programs, and an acceleration in merger and acquisition activity. Further, interest rates are low and the Federal Reserve is implementing a very accommodative policy. Also worth noting is that a mountain of cash remains on the sidelines even though money-market funds yield little or nothing. The alternatives to stocks are not very appealing: bond yields are low and their prospects are limited by credit issues and the threat of future inflation. The real estate market is moribund and likely to remain so until well into 2012.

We currently encourage investors to exercise patience and adhere to long term asset allocation guidelines and norms. Conservative investors may chose to exercise a higher than usual level of caution to adjust for the more elevated risk in the economy and markets and to increase their comfort level in what may well be a choppy market. We also recommend that investors maintain broad geographic and industry diversification in their equity holdings, take a longer term perspective in the midst of heighted volatility, and monitor closely the fundamental progress of companies in their portfolio. This is a time when it is necessary to have a high level of confidence in the fundamental strength of portfolio companies. Above all, investors need to be especially vigilant and flexible.

China Watch: Is Goldilocks Waking Up?

Almost a year has passed since we issued a blog “International Stock Markets: Searching for Goldilocks” (May 12, 2010). Here we pointed out that recent steps taken by the Chinese government and central bank to cool their economy and tame inflation had halted the sharp advance of Chinese stocks in 2009. Some investors feared that the policy makers’ initiatives would prove to be too little and too late, resulting in an inflation spike and asset bubbles. Others were concerned that the government and the central bank would become excessively restrictive and cripple economic growth. We offered three views:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.
• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.
• The “soft landing” would spark a strong stock market rally. 

Since our “Goldilocks” blog, Chinese inflation has continued its ascent from 2.8% last May to its current 4.9%. In response, the Chinese government has responded with a succession of interest rate hikes and bank loan restrictions, and Premier Wen Jiabao announced recently that the highest priority of government was to reduce inflation. Our forecast for Chinese stocks was lamentably correct: since the end of 2009, the Shanghai Composite Stock Index (CSEX) has retreated -11.3% and the exchange traded fund for Chinese stocks traded in Hong Kong (FXI) is off -1.4%. For the same period, the S&P 500 Index has risen 14.7%.

We think the Chinese policy makers are making progress and will be able to pilot successfully a soft landing. We also continue to expect this soft landing to renew the bull market in stocks dating back to March of 2009. We are not alone in these forecasts. In a March 15 report issued by Deutsche Bank titled “Turning Bullish on China,” Chief Economist Jun Ma argues that “recent developments are increasingly supportive of our view that year-over-year CPI inflation will likely peak in June at around 5.8%, then fall to around 4% in December.” He expects the policy makers to take their foot off the brake and considers the risk of a hard landing to be minimal. He concludes with the prediction that in the next twelve months the Chinese stock market will “rise about 25% from its current level.”

If Chinese inflation peaks in June, will the Chinese stock market anticipate this development and rally before the data confirms the fact? Is this already happening? Since January 25, the Shanghai market (CSEX) has gained 8.6%, whereas the S&P 500 Index has slumped -0.9%. We are very aware that anticipating events that do not materialize, or are delayed, can be very painful, but is it better to be too early than too late?

We are continuously reviewing Chinese stocks to identify the most attractive candidates to participate in a renewed stock market advance. Our focus is on companies that would benefit from the government’s massive infrastructure projects and/or would prosper from the rapidly rising demand for goods and services by the mushrooming middle class.