“Things done well and with a care, exempt themselves from fear.” Henry VIII, Act 1, Scene 2.
There are a lot of things to fear in the world today. The news headlines alone can churn your stomach: terrorist attacks by groups like ISIS can occur anywhere, provocative missile testings by aggressive nations like Iran and North Korea rattle other powers, and military expansion by the Chinese makes the South China Sea the probable theatre of tension for the next several years. And then there are worries of the financial-related sort. The United Kingdom (UK) is voting soon on whether or not to leave the European Union (EU), which could have far-reaching ramifications. Puerto Rico, a U.S. territory, is defaulting on its debts. And possibly the biggest financial anxiety centers on the world’s ballooning debt as economic malaise continues to be met with massive debt-incurring central banking policies–policies that appear to be yielding marginal results, at best.
MONETARY POLICY
The world’s economic and capital markets landscape, rightly or wrongly, continues to be shaped by the decisions of the world’s largest economies’ central bankers, so they hold most of the cards. Their policies have literally changed how the capital markets have functioned since the financial crisis began more than eight years ago, and the actions of these banks remain the focus of much attention, a reality likely to remain in place for years to come.
The U.S.’s central bank, the Federal Open Markets Committee (FOMC, the Fed) now finds itself in a really tough spot. Last December, after an extraordinary seven-year period in which the federal funds rate was held near zero percent, the Fed finally hiked the fed funds rate one-quarter of one percent (0.25%) and made clear their goal to raise rates four more times in 2016. However, in the first half dozen weeks of the new year, stock prices took a dive, oil prices continued to slide, and expectations of further rate hikes by the Fed vanished in short order. “How,” the thinking went, “can the Fed hike rates four more times in a year when domestic economic news is mixed, stock markets are struggling, and just about every other developed economy in the world is going in the opposite directions – lowering rates and implementing even more stimulus?” It came as little surprise when policymakers then scaled back the number of planned rate hikes from four to two after a Fed meeting in mid-March. The Fed lowered expectations further for official rates late that month when Fed Chair Janet Yellen cited “global growth risks” and inflation outlook “uncertainty.” The Fed worked deliberately to let the markets know it planned to pause on hikes.
Then, the landscape shifted yet again when headwinds became tailwinds. The price of oil and other core consumer goods changed direction and went up. Labor markets continued to improve. And with a rebound in equity prices and a fairly stable U.S. dollar, the Fed’s communication policy—the bedrock of the current policy framework— changed course yet again. The Fed’s focus has been on growth, jobs, and inflation, and with all three showing signs of improvement, they’ve changed their tune yet again. Now Fed officials are messaging to the markets the possibility of two or even three more rate hikes this year. Fed Chair Janet Yellen said that an increase in the federal funds rate “probably in the coming months … would be appropriate.” So we expect a hike soon, maybe as early as the July FOMC meeting. The problem is that such frequent directional changes to monetary policy create even greater swings of uncertainty in the financial markets and that volatility erodes confidence in the markets.
So, the Fed is in a tough spot. It’s held rates down far longer and far lower than it ever expected to – at least that’s what they tell us – and the U.S. economy may be strong enough to stomach another rate hike or two, but the other major central bank powers in China, Japan, and Europe are still implementing more stimulus and trying to drive their currencies lower versus the U.S. dollar. And if all of these forces work together to make for a stronger U.S. dollar, that makes our exports more expensive, which curtails foreign demand, and ultimately hurts our economy. It’s hard to make decisions when you’re in a virtual currency war. A tough spot… between a rock and a hard place… out of the frying pan and into the fire… take your pick of applicable metaphors.
BREXIT, ETC.
Anemic global growth is a concern for central bankers in the U.S. and abroad, and it’s also a major issue underlying what will likely be one of the summer’s biggest events – whether or not the UK votes to leave the EU on June 23. If voters in the UK choose to exit the EU, which has been labeled the “Brexit,” investors will scramble to figure out what that really means for them. As campaigning in advance of the vote heats up, there’s still no clear picture from the polls, although recently there has been a slight swing towards remaining in the EU. At this point, it’s still too close to call.
A decision to leave the EU would have far-reaching ramifications. First, a Brexit would come as a massive shock to global financial markets because the “unknown” slice of the global economic pie just increased dramatically in size. Also, the short-term impact on the British economy would be negative, and it might be enough to push the UK into recession. However, we doubt there would be the economic meltdown predicted by the British government and others passionately against an exit. More important than the short-term impact on the markets and on the UK economy is what a Brexit vote would mean longer-term for European and global economics and politics.
Leaders in the world’s largest economies contend the Brexit economic impact would pose a major threat to the global outlook. This seems an exaggerated claim as the UK accounts for just 2% of world output. A decision to modify its trading relationship with the EU and to pass on more political integration with the rest of Europe shouldn’t have a sustained impact on the global economy, especially as a Brexit would involve a transitional period lasting two years, and perhaps longer. This is where “Brexit anxiety” seems to look a lot like all of the handwringing that occurred over Greece’s “crises” just a few years ago. Eventually, world markets turned their attention back to bigger concerns.
A Brexit could have its most lasting impact on the political front – both within Europe and perhaps elsewhere. A vote to quit the EU would be the biggest blow to the European “project” to date. It would be viewed as a major chink in the EU’s armor, emboldening radical and separatist parties that have already gained considerable ground elsewhere in Europe, and it might encourage investors to question the irrevocable nature of the Euro as a single currency. Could we be looking at another wave of the sovereign-debt crisis? We think the vote will be to stay in the EU, but we’ll have to wait and see.
U.S. ECONOMY
June 2016 marks the seventh anniversary of the current economic growth cycle as the U.S. began its climb out of The Great Recession in the summer of 2009. It’s been the fourth-longest expansion in the post-World War II period and two years longer than the average expansion, and yet it’s not without its skeptics. Most of the cynicism is rightfully based on claims that this recovery has been helped along in large part by extraordinary monetary policy. That said, the U.S. economy is the envy of the developed world, save for China, which is growing faster than the U.S., but has its own list of problems to contend with.
The slow growth rate of the current recovery is often cited as one of its weaknesses, and analysts frequently point out that when growth slows to stall speed in any given quarter, the risk of recession is real. While this is true, slow growth is neither a sign of pending failure nor an endpoint, although it does make the growth cycle somewhat more vulnerable to exogenous shocks. This scenario played itself out again recently as revised first-quarter gross domestic product (GDP) came in at a paltry rate of 0.8% (annualized), only a few knots over what looks to be stall speed, to be sure.
However, there are positive aspects to the current cycle as well. Early in the recovery, there was an unusually high (and unhealthy) correlation between stock market volatility and hiring patterns. That trend has dissipated. Also important are recent signs of increased spending and investment on the part of the consumer. April’s retail sales gain of 1.3% was the largest monthly gain in more than a year. Perhaps the most recent positive news on the sustainability of the current growth cycle comes from the housing market. Recent data on sales of new and existing homes show we’re back to the volumes and prices we saw in 2007, before The Great Recession. The housing sector usually provides growth leadership in the first half of an economic expansion, but in the current cycle the recovery in housing was significantly delayed due to the last cycle’s housing bubble and bust and all of the misery that followed (i.e. foreclosures, debt and inventory overhang, and tightened lending standards). The fact that the housing sector is moving higher now indicates that the growth cycle may have legs. Now if only someone could make sure this housing recovery doesn’t balloon into another housing bubble… again.
MARKETS RECAP
The world’s capital markets are experiencing a so-so year thus far. The S&P 500, once down almost 11% in 2016, is now up about 3.5% year-to-date (through 5/31), with more than half of those gains coming in May. While no one knows for sure what the future holds, investors may want to think twice before jumping into the U.S. market with both feet, as it appears fully valued, at least on an earnings basis (trailing price/earnings ratio of 24, estimated P/E of 17.75). This may mean gains in the market will be limited until earnings growth can lead the way because concerns about global growth, valuations, and the course of U.S. interest rates have all kept the S&P from achieving new all-time highs for more than a year.
However, the U.S. continues to lead the world’s developed markets, which are down around 1% year-to-date. The index for emerging markets stocks is up a little more than 1% YTD, but it’s been a roller coaster ride as emerging markets were down more than 10% twice this year already and tumbled more than 4% in May alone. The U.S. bond market has seen gains this year of about 3.5%, rivaling U.S. stocks and with only a fraction of the volatility, pointing out again the value of owning a diversified portfolio. Commodities continue their rebound. Oil prices are up more than 30% YTD and are up more than 80% from their lows in February. Gold is up around 15% YTD, but was down 6% in May. It’s now obvious that the sell-off in commodities was overdone.
So we’re back to our quote from King Henry VIII: “Things done well and with a care, exempt themselves from fear.” While Henry was mistrusting, unfaithful, moody and greedy, he may have nailed it here – at least when it comes to investing. If you inform yourself by really knowing the facts and issues, and if you can then use that knowledge to develop a well thought-out plan, only then can you execute that investment plan, making small adjustments along the way. Investing – even in today’s topsy-turvy world – doesn’t need to be an exercise in fear. And for those who don’t want to walk through those steps alone, or for those who may want to delegate them to someone more experienced and less emotionally attached, then finding an advisor to work with makes a lot of sense.