Thoughts on the Current Outlook – April, 2014

The Weather Strikes Back!

It seems a bit ironic that we used a weather analogy as the framework for our 2014 outlook because the weather itself was the biggest economic story in the first quarter. East of the Mississippi, from Minneapolis to Washington DC, record cold and snow were served up repeatedly.

Against this frigid backdrop, retail sales slowed, car sales stalled and hiring took a hit. About the only thing contributing positively to a growing economy was the big increase in consumption of natural gas for heating! We don’t have a preliminary read on GDP for the first quarter yet but we expect it will be significantly slower than the fourth quarter’s 2.6%.

The weather-induced slowdown in the economy had another surprising effect: the bond market did better than stocks in the first quarter. By the end of 2013, bonds were all but given up for dead with most predicting that interest rate rises were imminent and a bond bear market was about to start. And, conversely, conventional wisdom was that stronger economic growth would help stocks. As is usually the case when a trend is so universally expected, something else happened.

The bond market seems full of surprises these days. Even with new Fed Chair Yellen signaling that interest rate hikes are likely to begin next year, longer term bond yields have barely budged. To be fair, intermediate term rates moved up and mortgage rates continue to creep up. But, the worst performing part of the bond market in 2013 – long term municipal bonds – were the star of 2014’s first quarter.

But Change Is in the Air

Despite all of the uncertainty created by the weather, there is one thing that is certain: the weather will change. And, with it, we expect that economic activity will resume at a respectable pace. Respectable is the key word here. There are many factors that will keep the economy from accelerating too quickly.

First, we believe the snapback in housing is now over and the future gains in home prices will be driven by longer term supply and demand dynamics. While those dynamics are favorable, double digit price gains are likely behind us and more consistent, inflation plus 1-2% gains are more realistic.

The employment picture is still solid, if unexciting. Except in a few, high-skill, high-demand fields, there is still a great deal of slack in the labor markets, meaning income growth will be restrained and wage-driven inflation will be non-existent.

Finally, consumers continue to be financially conservative, taking on little debt and using their credit cards sparingly. This is one of the positive legacies of the Great Recession. But it also constrains growth in our economy.

More Excitement Elsewhere

Ukraine is in focus as the world ponders Russia’s next steps after its annexation of Crimea and troop build-up on Ukraine’s eastern border. We have long expected Russia to use its energy influence and the war-weariness of the US to expand its regional influence. We believe that the markets are Putin’s biggest adversary – the ruble has plummeted and, if oil prices follow, his ambitions will be diminished.

The more important European financial story is its emergence, albeit very slowly, from recession. The peripheral economies still have a long way to come before they can claim recovery. Indeed, central bankers are concerned that inflation remains too low, with talk of more stimulus creating news. Discussions about a possible break-up of the common currency, all the rage just a couple of years ago, are all but dead.

India, the world’s largest democracy is about to embark on its largest election (800 million prospective voters) ever. At stake is a renewed focus on the economy, which has struggled to post decent growth of late. India is in great need of more forceful economic leadership but we remain skeptical whether this election will provide it.

In China, concern has shifted to the magnitude of the debt build-up over the last few years, even as growth has slowed. From a very big picture perspective, this combination of factors is very similar to the US situation in the mid 2000s. As we know, that did not end well. However, there are many, many differences between how China and the US are able to manage these circumstances. We expect the Chinese to accept much lower economic growth as they shift toward a more sustainable growth model. And, they will use their unique “market-oriented” approach to gradually introduce freer float in the currency and more risk of default into the debt markets.

Finally, in Japan, Abenomics has accomplished its first task of shifting psychology away from deflation to modest growth and inflation. Salary growth, a critical element of the shift, is showing signs of taking hold. An increase in the consumption tax is just now going into effect so the next several months will be critical in seeing how this impacts the economy.

The Bottom Line

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We have reduced our dedicated Asia investments but have increased the weightings in international small company stocks, expecting these strategies to perform well in a better economic environment. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to changes in market expectations about the future course of interest rates.

April 9, 2014              © Essential Investment Partners, LLC