Economic Optimism Remains in Spite of Questions
At the end of a positive-looking first quarter, there are many questions begging for answers. Are stocks overbought or overvalued considering the Dow is sitting at all-time highs after significant runs in 2012 and early 2013? Are we about to see a wave of inflation as a result of extraordinary monetary policy easing? Will interest rates rise? Will the economy return to normalized growth rates? There are plenty more questions, but these are perhaps the most pressing.
Let’s start our discussion with a summary review of the backdrop.
|Globally coordinated monetary policy easing
||European debt crisis
|Healthy corporate balance sheets
||High debt-to-GDP ratios in developed markets
|Improving housing market
||Gap between industrial capacity and demand
|Modest inflation with low interest rates
|Improved bank health and lending activity
||Low savings rate
|Growing U.S. energy independence
||Falling real wages
|Wealth effect from rising stock markets
||Fixed income valuations
|Reasonable equity valuations
||Uncertainty over debt ceiling and future tax policy
Monetary easing and credit expansion
Despite what appears on the surface to be a modestly improving economy, the Federal Reserve, and indeed nearly every central bank in the world, is maintaining a policy of monetary easing. Why?
The developed world continues to face significant deflationary pressures from:
- A substantial output gap arising from the difference between diminished aggregate demand (ability to consume), and expanded aggregate supply (ability to produce)
- Falling real (net of inflation) wages
- Overall debt deleveraging (lack of credit expansion)
- Abnormally low savings rates
- Above-average levels of unemployment and underemployment
In this environment, it is necessary for the Fed to maintain easy policy to facilitate credit expansion through low cost and high availability of capital. In consumption-based economies like the United States, given the deflationary pressures noted above, it is not possible for consumption to increase without an expansion in credit, and consumption accounts for roughly 70 percent of GDP output.
We can debate the merits of an economy that is reliant on credit expansion, but the fact of the matter is that we remain precariously close to recession even now. There is little room for consumers to expand their consumption levels. As noted earlier, they are currently only saving 3 percent. A modest drop in consumption or an increase in the savings rate to normal levels would likely result in recession, and perhaps deflation.
Policymakers have been attempting to fill the deflationary output gap through massive stimulus programs. They fund these programs primarily by issuing debt and expanding the money supply (increasing the number of dollars in circulation). And, policymakers attempt to provide support for consumption via income transfers (redistributive tax policy).
Current monetary policy has also been described as “financial repression.” It is harming investors by reducing yields on investments to abnormally low levels, and it is discouraging savings. As noted earlier, it is reasonable to argue that this policy was both necessary and successful in averting depression. But it is also reasonable to argue that there will be a day of reckoning. To increase the money supply, the Fed is printing money, which in modern terms means increasing it electronically. With this extra currency, the Fed is buying U.S. Treasury securities.
Current purchasing patterns show that the Fed is purchasing roughly 70 percent of all debt being issued by the Treasury. Having such a large buyer of our debt has allowed the government to accumulate debt much more quickly than through the normal functioning of the markets.
In addition, there is no “price discovery” within the federal securities market. Given that the Fed is buying most of our debt, it is intentionally setting the price for all Treasury securities and suppressing yields everywhere. This strategy raises a few questions:
- Who will buy Treasury securities, if not the Fed?
- What would happen to the price of these government securities if they were set by the market?
- Will the Fed eventually be able to exit its extraordinary monetary policies?
If the Fed were to exit its extraordinary policy measures, we believe the resulting fall in prices and increase in yields would significantly raise the country’s cost of funding. Given that the net interest cost to carry our debt is already 6 percent of GDP, allowing yields to rise is all but unacceptable.
Therefore, it is our view that interest rates will not be permitted to rise for years. There may be modest increases over time, but it will likely be years before rates normalize. We hold this position even if there is evidence of inflation (which already exists in agriculture). However, as noted earlier, it is unlikely we will experience widespread inflation at least for a few years.
What might lead to inflation?
We expect inflation will accelerate when 1) credit begins to expand significantly, 2) business spending accelerates sharply, or 3) the Fed begins to aggressively devalue the currency. While we expect business outlays to accelerate, it is not likely to be enough to be inflationary; spending is usually meant to improve productivity. What’s more, higher productivity often leads to lower labor costs, pushing down both wages and consumption. Of course, business expenditures are often geared toward creating revenue opportunities or expanding capacity, but just concentrating in these areas is insufficient to drive up inflation.
While currency devaluation may seem conspiratorial, it has been employed before, and is quite likely to be employed again given our rapidly growing debt and the Fed’s desire to increase our inflation rate. A weakening dollar is, by definition, inflation. Goods and services don’t become more expensive over time because they’re more valuable, but because the dollar becomes less so. Certainly, a weaker dollar does have some benefits — it tends to boost exports by making our goods less expensive in other markets. A weaker currency also means that we are paying on our debt with less valuable dollars.
Source: Federal Reserve
As shown in the chart, inflation is currently running at about 2 percent, well within the Fed’s target of 2 to 4 percent. The president is considering a policy change affecting the Consumer Price Index (CPI) and the cost of living adjustments (COLA) to entitlements. In the last issue of this publication, we suggested that there might be a change in the construction of CPI for these very reasons. And now, here it is. Knowing that our entitlement programs are already under funded, reducing future increases via COLA is one way to significantly reduce program costs over time. Reconstructing the composition of CPI to understate actual inflation will also allow the Federal Reserve to continue its easing policies further into the future.
Housing continues to improve
As indicated in the January 2013 issue of Market and Economic Outlook, housing starts have continued to improve for the past seven months, up to a roughly 900,000 annualized rate. This is still well below the 1.5 million per year average of the last decade, but that number is suspect due to the distortions of the former housing bubble. Furthermore, home prices have begun to move up, which has several obvious benefits. Rising prices improve the debt-to-equity ratio of most existing homeowners, many of whom may be emerging from being “underwater” on their mortgages. This positive turn increases their wealth, liquidity, and mobility. It also improves the credit quality of mortgage pools, which opens up additional capital for financing and leads to improved availability of financing for marginal borrowers. We stand by our view that improvement in this space will add roughly 0.75 percent of additional GDP output.
Equity valuations are reasonable
Though the domestic equity market has been moving up in recent months, valuations are still reasonable because the earnings-per-share performance of most companies has also been improving. The S&P 500 is trading at roughly 16 times trailing earnings. However, the S&P 500 is trading at roughly 13.8 times consensus estimates of forward earnings — a more reasonable ratio relative to history. Certainly, we don’t expect that markets will move up unabated. Indeed, we expect periods of volatility and setbacks. It’s also fair to acknowledge that by some measures, such as cyclically adjusted price to earnings, stocks are becoming expensive. We may disagree with some of these valuation measures, but we can not dismiss them.
With this in mind, we must also compare equity valuations relative to other financial assets. With cash and short-term Treasury securities yielding 0 percent and longer-dated Treasury securities, municipals, and investment-grade corporate bonds all yielding around 2 to 3 percent, it is clear that fixed income securities offer limited opportunities. Indeed, if interest rates stay the same, the very best that can be achieved will be real yields (net of inflation) that are below 1 percent. If interest rates were to rise, even modestly, returns on bonds may turn negative. Of course, if interest rates fall, returns could be above average, but that is certainly not the outcome we expect. Simply stated, bonds are far more expensive than stocks. All things considered, we feel that stocks are fairly valued, but still offer attractive risk-adjusted return potential relative to other asset classes, including bonds, commodities, and cash.
Healthy corporate balance sheets
In most developed markets, and the United States in particular, corporate health is excellent, with many businesses enjoying record profit margins and high overall profitability. The earnings denominator in the price/earnings ratio is the reason stocks are reasonably valued. Businesses are also sitting on record levels of cash, which can be used for capital expenditures, stock buybacks, dividends, or mergers and acquisitions — all productive uses, and all supportive of a rising stock market.
Growing energy independence
As noted in the last issue of this publication, the United States is moving rapidly toward energy independence. We have virtually inexhaustible supplies of natural gas according to the U.S. Energy Information Administration. The same agency forecasts that we’ll be the world’s largest producer and a net exporter of oil by 2020. New technology has allowed us to extract far more out of old wells and from oil shale. By the end of this year, the United States will likely produce as much oil domestically as Saudi Arabia.
Producing our own energy supplies has tremendously positive implications for our economy in the form of jobs, domestically produced and retained profits, and tax receipts. It should help narrow trade deficits as Japan and other trading partners clearly need a friendly and cheap source of both natural gas and oil. There are additional positive implications for both foreign policy and reduced military presence and expenditures overseas.
Excess capacity and low industrial production
Companies are enjoying record profits and profit margins even though they still have excess capacity and soft top-line growth. They have been particularly adept at adjusting their operations, having dramatically cut capital expenditures, payrolls, and debt levels. While we expect capital spending to increase because some equipment (particularly technology) has a finite life cycle, increases are likely to be modest for several reasons. First, many organizations are still running well below capacity, negating the need for new equipment to improve productivity (and negating the need for more labor too). In addition, sea-change advancements in technology (cloud computing, tablets, and smartphones, for example) have dramatically changed the hardware needs of most businesses. Gone is the typical three-year upgrade cycle for expensive desktop and laptop computers.
Uncertainty in Europe
In our view, the future of the European Union (EU) is still uncertain. Poorly capitalized banks and the marginal solvency (or insolvency) of the Mediterranean members are systemic risks that will take years to repair and will require greater integration and joint liability among all participants. We still believe Greece will be forced to exit the EU when policymakers are convinced that such an exit will not cause a cascade of failures among the banks that hold their debt.
In mid-March, EU officials floated a trial balloon in Cyprus — a 10 percent tax on uninsured bank deposits — as a condition linked to a bailout package. Cyprus was conspicuous because of its very small size, suggesting officials wanted to gauge reactions to the policy in a small market. The Cypriots wisely rejected the EU policy.
What’s remarkable is that officials actually suggested such a policy. Even though Cyprus is an exceptionally small market relative to the EU, they risked a bank run across the region. Depositors rightfully began withdrawing cash from ATMs, and businesses like restaurants started taking cash only. If the wealthy believe their deposits are to be confiscated or inaccessible, then they will remove their deposits to a safer region. Starving banks of deposits is a sure-fire way to put them at greater risk of insolvency, which also leads to illiquidity among other banks as overnight lending evaporates. We were astonished that EU officials could be so reckless. It’s clear they don’t really understand how markets work.
There has been talk that the Cyprus policy was targeting Russians who were laundering money. That may be, but putting an entire financial system at risk just to get to a few wealthy depositors is beyond foolhardy. It will take the European markets some time to regain trust that another similar policy is not in the offing. Remarkable.
After 24 years of recession, on and off deflation, and a 70 percent decline in its equity markets, we think Japan now provides an interesting investment opportunity. Though Japan is the most indebted country in the world, with a debt-to-GDP ratio around 250 percent, it has experienced an economically debilitating rise in its currency over this period. An overly strong currency has impaired the nation’s export competitiveness and stifled profit growth. The yen has appreciated strongly because large pensions and wealthy individuals have continued to buy government bonds in the deflationary environment, pushing the currency up even further and exacerbating deflationary pressures.
Political changes in the country have led to a new pro-growth administration and central bank policy is now actively targeting an over-valued yen. Indeed, the central bank has already pushed the currency down roughly 20 percent over the past few months as shown in the preceding chart. We have reason to believe Japan will devalue its currency another 20 to 50 percent. If correct, this will certainly benefit Japanese stocks. It is an export-based economy and a weaker currency would greatly improve export competitiveness. Such improvements will dramatically raise revenue, profits, and tax receipts, and permit the government to pay down debt with devalued currency. Of course, this also means that input costs for energy and materials will be higher.
Regardless, after more than two decades, Japan is now very appealing, with equities of world class companies domiciled there being extremely cheap. We wrote about China and Asia in general in our last issue. Needless to say, our short-term and long-term outlook for many Asian regions is quite bullish.
Looking ahead, we like what we see
Though the market is up significantly and trading at historically high prices, and the economy is unlikely to accelerate meaningfully, stocks remain compelling on a relative basis. Further, there are opportunities in certain asset classes and regions which are particularly appealing. The risks in Europe are sizable, so we remain cautious on that region. However, in the United States, the risks are mostly attributable to potential policy (tax, fiscal, and monetary) mistakes. On balance, we find ourselves cautiously optimistic for the year.
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Mark A. Griffin, CIMA®
CLA Wealth Advisors’ Disclaimers
Principal, Chief Investment Officer