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Note for March Investment Committee MeetingSubmitted by The Wealth Consulting Group on April 21st, 2016
Summary and Conclusion:
I conclude, as I did last month, that the bond, equity, and commodity markets should remain volatile over the coming month. The primary source of uncertainty, particularly in the bond market, is the uncertainty of the expected path of interest rates during 2016. The path of oil prices and the pace of development policies, especially in China, with their effects on the level of international reserves will contribute as well.
The FOMC decision at the January FOMC meeting left the Fed Funds rate target unchanged and gave little additional guidance (that was not included in the December Press Release or Minutes) for the future path of the Fed Funds rate. The minutes of the January meeting and Chair Yellen’s testimony before Congress gave us little further guidance on the path of rates; (moves are data dependent). Recent comments by FOMC members during the market turmoil in January and early February indicated that the Committee is less likely to raise rates in March, but more recent comments indicated that a rate rise might still be on the table. Recent published economic data as well as a reversal of the selloff in equity markets justifies a 25 basis point move in March. Since the market assigns a zero probability of a move, a Fed Funds rate increase at the March meeting is at best a 50-50 proposition. Bond and equity markets will move on the decision based on an unexpected increase in rates if that is the decision, or changes to the dot plots and the economic forecast that will be necessary to support leaving the rate unchanged. [It is still too early for the U.S. elections to have much of an effect on equity markets, excluding bank stocks and pharmaceuticals.]
The continuation of volatility is based on relatively low liquidity in some markets, unbalanced bets in some futures markets, and the uncertainty regarding the outlook for economic activity – especially in the Emerging Markets. It is possible that the equity market could continue its bounce-up and enter the critical range of 2160 to 2240 on the S&P 500. I think in the near term (the coming month) this is unlikely because earnings are still declining, the dollar remains strong, and foreign economic activity is weak, deflating earnings abroad when denominated in in dollars. If the economy registers a significant shock (a significant shock would be the continuation of the sharp drawdown in international reserves by China, Russia and Saudi Arabia that we saw in January and early February) before the S&P reaches its critical interval, the late summer grind down scenario with large daily moves both up and down (but with the downs dominating the ups) due to low liquidity, a dearth of both buyers and sellers, will re-appear. Barring negative supply shocks, dollar prices of primary commodities should remain weak relative to 2012. The situation in Syria is an international political crisis waiting to happen – rumors of Turkey and Saudi Arabia entering the ground war and Russia actively supporting Assad open the door for violent confrontations among the three parties. The recent negotiations regarding a cease fire should do little to lower these risks. The flow of migrants resulting from the civil war in Syria is causing political instability in the European Union. China’s exchange rate policy has not moved as much toward a more market determined exchange rate as I had expected (hence greater drawdowns (and builds) of international reserves rather than more volatility with respect to the dollar). Instead, with the RMB’s inclusion in the SDR and most likely a more widespread use of the RMB as a reserve currency, the risk is that China will continue to drawdown international reserves as countries are more willing to settle international transactions in RMBs.
Economic activity in the Advanced Economies is moving toward its full employment growth path, although most analysts have reduced growth forecasts due to a weaker outlook for Japan and the United Kingdom. The U.S. economy grew 1.8% (Q4/Q4) during 2015; advancing at a disappointing 1.0% (annual rate) pace in 2015Q4. The Atlanta Fed’s estimate of 2016Q1 growth (GDPNOW) is 1.9%., as the recently published data indicate a bounce-back from a weak 2015Q4. The consensus forecast for U.S. growth in 2016 is 2.25%, a bit lower than the last FOMC forecast of 2.4 percent, and at least 0.25 percentage points higher than the full employment growth rate. Note that despite the 2015 (Q4/Q4) growth rate of 1.8%, the unemployment rate continued to decline indicating that it is doubtful that the full employment growth is as high as 2%; a feature of the data during the past 7 years.
The Euro Area is estimated to have grown 1.5% during 2015 and is expected to advance at a 1.6% rate in 2016. The Euro area as a whole had recovered from its latest recession but the migration crisis along with the political fallout from the influx of migrants lends a distinct down-side risk to this projection.
The United Kingdom grew 2.2% in 2015. The consensus forecast for U.K. growth in 2016 is 2.3%.
Looking at the Advanced Economies as a whole, they are estimated to have grown 1.8% in 2015 and are expected to grow 1.4% during 2016.
The Emerging Market Countries are slowing down. Brazil and Russia are in recession; Brazil is struggling from poor policies and a political crisis due to corruption (in Petrobras no less); Russia is slowing down due to sanctions and low commodity prices. China’s economy is slowing from its 7.3% pace of 2014, but there is little consensus on how much they have or will likely slow down (as well as little belief in the validity of their published numbers). The data currently circulated for China estimate growth in 2015 of 6.9% and project growth in 2016 of 6.7%. The negative shocks that both China and Russia have sent to international financial markets appeared to have eased considerably in late February. China drew down international reserves by roughly $90 billion during December 2015 and the drawdown is reported to have continued at a similar rate during January. (This contraction of dollar money supply weighed heavily on the prices of primary commodities and equities, and caused an appreciation of the U.S. dollar.) I don’t believe oil prices will recover until Saudi Arabia alters its firm stance to maintain production at high levels until other producers – both OPEC and Non-OPEC -- agree to cut production. The Emerging Markets are believed to have drawn down reserves in excess of $1 trillion since July, 2014 (the latest published numbers are January 2015). Of this more than $1 trillion drawdown, China ($770 billion), Russia ($110 billion), Brazil ($26 billion), and Saudi Arabia ($100 billion) account for $1 trillion. As I explained in my presentation last May, this drawdown of reserves acts as a monetary policy contraction that causes an appreciation of the dollar, a decline in primary commodity prices, and a reduction in other asset prices in dollars including equities and yields on bonds. The RMB appreciated from a value of 6.4 RMB/$ on August 27th to 6.32 on October 30th, but has since depreciated back to 6.53 RMB/$.
The consensus forecast of economic growth in the Advanced Economies appears promising, I remain skeptical that growth will rise above its potential rate, which is somewhere between 1.5 and 2 percent. The United States expansion is getting ‘mature’, so U.S. growth should advance close to potential. Therefore, I would expect growth during 2016 to be closer to 1.5% than the Fed’s projection of 2.4%. (The weaker outlook would tend to favor the market’s projection of two 25 basis point rate rises during 2006 rather than the median FOMC dot plot of 4 such increases.) The weak investment on machinery and equipment, both past and current, dictates continued low productivity growth – consistent with our convergence thesis. Without higher productivity growth, it will be difficult to reach above 2% GDP growth absent an unanticipated large growth in the labor force. The other Advanced Economies face headwinds similar to those experienced by the U.S. economy from 2010 to 2014, so growth above potential in these areas seems a bit of a ‘rosy’ scenario as well. To the extent that asset markets are taking on this strong forecast, markets are subject to a surprise that could lead to adjustments in equity valuations downward.
Drivers of the Recent Bull Market:
Globalization and the aggressive development policies of the large emerging market economies have been the key drivers of the post financial crisis bull market. The key forces that spurred globalization are the improvements in transportation and communication that enhanced international trade and capital mobility. Russia, India, China, and South Africa re-connected with the world economy and along with Brazil embraced aggressive development policies. These development policies aimed to increase income per capita by raising productivity growth. Economies increase productivity growth through investment. Thus these investment growth policies embraced in countries with large populations increased the demand for capital, hence the price of capital, placing downward pressure on interest rates. The addition of these countries with large populations essentially doubled the world labor force, placing downward pressure on wages, worldwide, because of capital mobility. These policies resulted in emerging market economies growing faster than the advanced economies – an outcome called the new normal by Mohammed El Erien and structural stagnation by Larry Summers. (I called this phenomenon convergence.)
U.S. macroeconomic policy focused on preventing deflation on goods and services prices. The key to preventing deflation on goods and services prices is preventing declines in nominal wages. With nominal wages rising, albeit slowly, and globalization driving up the price of capital relative to the price of labor, equity prices rose significantly because equity prices reflect the value of the firms underlying assets as well as the discounted present value of future earnings.
When it appeared that the bull market had pretty much run its course toward the end of 2012, the U.S. capital gains tax rate on affluent households (holders of a disproportionate share of equity value – I have seen estimates of 80%) rose 59% from 15% to 23.8%. This rate increase removed a large share of equity holders out of the sell side of the market and led to a 30% plus increase in equity prices in 2013 and has contributed to a further 24% increase during 2014, before flat-lining during 2015 and then declining during January before rebounding in February, but still at a level below its highs in the summer of 2015. This 54% increase in equity prices is in sharp contrast to subdued price performance of other assets such as oil, metals, and even gold. If the equity price was driven by Fed (and international dollar) monetary policy, all asset prices would be marching up in lock-step like the dollar money supply driven asset price increases of the first half of 2008 and decreases during 2008H2.
The Driver-less Market:
Recent macroeconomic (and political) developments are changing the bull market’s calculus and help explain the key features of the 2015-16 market – periodic volatility with no direction. The pick-up in economic activity in the Advanced Economies and the slowdown in the Emerging Market Economies stems from a change in policy in the Emerging Markets – primarily in China and Brazil – and a change of emphasis in Russia. (Thus these policy changes signal the end of El Erien’s new normal -- which was neither new nor normal. El Erien has recently commented on its demise.) As China attempts to shift its growth strategy away from investment and exports to consumption and services, China will experience a lower build-up in their capital stock, a slower increase in its capital/labor ratio, lower productivity growth, and lower growth of potential output. Therefore, the convergence between China and the Advanced Economies will likely slow, the Advanced Economies will retire capital at a slower rate, allowing them to grow at a faster rate than they experienced during the past ten years. I pointed out this risk during my presentation in May. However, China’s productivity growth will still outpace that of the advanced economies, so as long as China manages its exchange rate at a constant or depreciated level, its exchange rate policy will send deflationary shocks to the Advanced Economies that, along with their change in development polices, will act as a tightening of monetary policy that will reduce asset prices to include those of equities and bonds. The recent depreciation of the RMB sends a warning concerning the risk of this deflationary shock.
In both China and Russia, political exigencies have taken priority over economic development. In China, the move from export led growth to domestic consumption and services has turned into an excuse for a political purge and a consolidation of power under Mr. Hu. The purge indicates a change in the “rules of the game” in China, increasing uncertainty, and discouraging investment – especially by foreign capital. In Russia, perceived threats, in Russia’s view, to its spheres of influence has shifted priorities away from development toward actions in Eastern Europe and the Middle East that have led to sanctions which have hurt economic development (Russia is currently in recession) and trade. With China’s investment and industrial output slowing, the demand for commodities (particularly oil) declined sharply and the prices of commodities tanked. The fall in commodity prices sharply reduced income from oil exports in Russia and in other large oil exporting countries such as Saudi Arabia. This lower oil income led oil exporters such as Saudi Arabia and Russia to draw down their international reserves in order to support their currencies (Saudi Arabia is on a tightly fixed exchange rate.). This drawdown of international reserves has reduced the supply of dollars, leading to an appreciation of the dollar, downward pressure on U.S. export earnings in dollars, and downward pressure on U.S. equity prices, contributing to the difficulty that the U.S. equity market is having to cross that 59% threshold.
The reasons for the volatility last month are many (to include the low liquidity reflecting reluctant buyers and the absence of sellers due to the capital gains tax increase) but the most significant was China’s and Russia’s management of their foreign exchange rates that resulted in changes both positive and negative in the value of international reserves. With the low commodity prices, commodity exporters have contributed to these shocks as well, as they drawdown reserves to manage the value of their currencies.
The second contributing factor was the uncertainty regarding both when the Federal Reserve’s Open Market Committee (FOMC) will raise the Federal Fund’s Rate and what the effect of its action will have on the economy and on equity markets. In December, the market placed a high probability on a 25 basis point increase and Fed moved rates as expected. Going forward, the market and investors will focus on the pace and the increments of rate increases. All FOMC members (at least in the December Projection Materials) project at least two 25 basis point moves during 2016, a pace and increments priced in the markets. (The median projection of FOMC members is four 25 basis point increases.) As I mentioned above, this projection is based on an economic projection on the high end of the range I would expect in 2016. January statements by Board Vice Chair Fischer, Richmond Fed President Bullard, Boston Fed President Rosengren, and New York Fed President Dudley indicate the possibility of a slower and lower Fed Funds rate increase. More recent statements by Dudley and San Francisco Fed President Williams indicate a March increase may be in play.
I believe the market (at least market analysts) is still expecting higher medium-term
growth in the United States and in other Advanced Economies than will manifest because of a lack of appreciation of the role that globalization via convergence among advanced and emerging market economies plays in the lack of investment and slowdown in productivity growth in the United States and other Advanced Economies. Revisions in the GDP data released in July strengthen the case for “convergence” to be the primary cause of the slow growth in potential output. Since the evolution of China’s economy is an important element in this calculus, the success (or lack thereof) of China’s switch from export led growth to a service driven consumer society will affect the potential growth of the Advanced Economies including that of the United States. Counterintuitive to some, deceleration in growth and development in China and Brazil should lead to more investment and growth in the Advanced Economies.
The political focus on inequality and the possibility of concomitant (outsized) increases in minimum wages will work its way through the U.S. economy’s wage structure and will likely produce higher inflation than expected over the next several years. The wage increases reflected in the February 5 jobs report (and the core PCE prices in the Personal Income report) indicates that this phenomenon may well be taking place. Accelerating inflation should place up-sized pressure on long-term interest rates and allow the Federal Reserve to justify a rise in short-term rates despite stagnant growth. (Although the profession has not clearly shown whether higher inflation causes higher interest rates or higher policy interest rates cause higher inflation, John Cochrane (University of Chicago) is circulating a paper claiming the latter, a view that I share.) Higher wages, stagnant growth, and an appreciated exchange rate will likely depress earnings and put downward pressure on bond prices and on equity prices.
Implications of Economic Volatility for Client’s Portfolios
Given the heightened level of uncertainty in markets (i.e. the volatility in global equity markets) and the effects of possible shocks (China’s development and exchange rate policy), the FOMC rate decision and its forward guidance, and the risk of a negative or positive oil shock in the Middle East) the investment committee should investigate strategies to mitigate the risk of a significant drop in equity prices if such insurance is appropriate for the firm’s clients. This recommendation is based on the logical effect of a known shock that has already occurred and the shock’s effects have manifested as predicted over the past three years. At least, if appropriate, your customers should be prepared to re-weight toward equities – buy on the dip -- if such a decline in equity markets occurs. Of note, a number of stocks have made a 30% to 40% correction already.
The convergence among Advanced and Emerging Market economies implies a significant restructuring of the U.S. and other Advanced Economies. It would be wise to review clients’ portfolios to mitigate holding shares of companies that might fare poorly or perhaps disappear (Penn Central Railroad in the 1970s) due to this restructuring despite performing well in the pre-globalized world. High wage, low technology firms with production facilities in the United States and other Advanced Economies will not fare well in this environment, even if they have done well in the past.
Whither China’s Development Policy and its Exchange Rate Policy:
China’s rapid investment relative to that of the United States means that China’s productivity has grown faster than that of the United States and the Rest of the World. Since China is reducing its emphasis on investment, industrial production, and exports relative to consumption, China’s productivity growth will likely slow and its rate of real appreciation of its currency will likely slow down. The change in emphasis toward consumption will likely slow down the desire of firms to invest in China for the purpose of export and will likely slow, or perhaps even reverse, the buildup in international reserves. Because of China’s size, a decline in investment will lead internationally to a decrease in demand for capital, lowering the price of capital, and put downward pressure on equity prices. A decline in China’s U.S. dollar international reserves acts as a tightening of U.S. dollar money supply that will likely lead to a nominal appreciation of the dollar vs. other advanced economy currencies, a slowdown in U.S. growth, a decline in primary commodity prices, and, if sustained, a decline in equity prices. China’s international reserves have declined during the past year and we have seen the effects listed above, including a decline in equity prices, but not the reversal of the upward movement due to the capital gains tax increase. Note that uncertainty regarding the rules of the game, due to the anti-corruption drive (Is it just another political purge?), could be depressing investment in China as well.
The FOMC’s Interest Rate Decision:
The FOMC maintained the Fed Funds rate unchanged at the January meeting at its current, effective rate of 38 basis points, as expected. The market does not see the FOMC reaching their terminal Fed Funds Rate of 3.5% any time soon. I think the decision at the March meeting is a coin toss at present. The February jobs report and the GDPNOW estimate of 2016Q1 U.S. GDP growth support a continued normalization of rates. Market volatility has had little effect on the real economy (as expected – numerous studies over the years in many markets have shown this to be he case). The market will most likely react to FOMC member chatter on their views on the pace and magnitude of increases in rates. Currently, the market is projecting no increase in March and a pace of increases slower than the FOMC’s median projection of December dot plots (which lists a median rate of 100 basis points at the end of 2016) and a lower end point than the Fed’s 3.5%. The FOMC will update its dot plots and economic projections at the March meeting. Thus, this difference between the Fed’s projections and the markets expectation will no doubt be significant so I would expect significant market volatility following the press release and during Chair Yellen’s testimony. At least in the short-term I would expect volatility that affects yields throughout the duration of the yield curve and equity prices.
William L. Helkie
William Helkie is not affiliated with LPL Financial.
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