Volatility in Surprising Places

With two major bear markets in stocks within the last 15 years seared into investors’ memories, we have come to expect high volatility in stock prices. Conversely, we tend to view the US economy as a lumbering giant, moving slowly but constantly forward, with only something as large as the Great Recession able to throw off its trajectory.

Lately, we have seen volatility in the stock market decline rather dramatically. Actually, this is pretty typical of a sustained run of positive returns like we have had since the middle of 2011 and we also saw in the mid 2000s. However, we have seen the opposite in reported GDP over the past year. The quarterly numbers have bounced around a lot (+4.1%, +2.6%, -2.9% and +3% estimated for the last four quarters). If we just look at the year over year increase though, we find that GDP has grown at less than 2%.

This raises a couple of questions. Is 2% as good as it gets, now that the economy seems to be hitting its stride in this long recovery? Does 2% growth really support the kind of rally we have had in stocks?

We believe there are a number of structural reasons why this 2% level of growth may be closer to the economy’s new growth potential, down roughly a third from the 3% we became accustomed to for several decades. Productivity growth has slowed for at least two reasons: (1) chronic underinvestment in business capital equipment in the post-Great Recession period and (2) changes to the size and composition of the labor force occasioned by demographic shifts. While productivity will be boosted somewhat by advances in mobile technology, these other factors will likely offset that boost, holding our growth back.

There is both good news and bad associated with lower potential GDP growth. The good news is that we need fewer new jobs to sustain employment at a relatively high level (we are seeing this play out in the rather quick drop in the unemployment rate over the last 18 months). The bad news is that we could be much closer to triggering a bout of renewed inflation from wage pressures than the Federal Reserve currently believes. And, on a cyclical basis, we are getting close to a point on capacity utilization that typically results in inflation pressures.

From an investment perspective, this result is by no means terrible. Growth at this new potential with renewed wage inflation will mean higher nominal GDP growth. Corporate profits and stocks can likely grow at that nominal rate. Interest rates on bonds will drift up to at a more normal spread to long term inflation expectations (elimination of Fed buying will let rates seek this natural level). Overall, we should expect returns to be lower than those of the last three years, when both stocks and bonds did quite well.

Returning to the second question of stock prices relative to growth prospects, we view US small cap stock valuations as very stretched and US large cap stocks as fully valued. As we look at individual companies, we often see valuations that reflect a great deal of optimism about earnings growth when the reality is that earnings will likely grow slowly. It takes a great deal of searching to find growing companies at reasonable prices. We are much more positive about the prospects for non US stocks as growth is beginning to accelerate and prices are lower.

Global Growth Takes a Positive Turn

Globally, we see economic growth trending more positively with renewed contributions from Japan and Europe offsetting lower growth in China and many other emerging markets. In Japan, the long-awaited, third and critical arrow of Abenomics will soon be announced. It will be interesting to see how bold Mr. Abe will be in his proposals for labor market reform and, if he is bold, whether the Japanese people will continue to support him. Please see the previous blog post on this website to read our publication about Japan entitled Big Change in the World’s Third Largest Economy?

Continental Europe is still struggling to emerge from recession. The process is slow and central bank stimulus continues to expand. Without a strong central force for fiscal stimulus, the European Central Bank’s monetary stimulus is the only game in town. The ECB is still fighting off the effects of fiscal austerity plans put in place across southern Europe several years ago. Those economies are now bouncing back after severe recessions. On the other hand, the UK, which retained control of its own currency and fiscal matters, has recovered well from recession and is now looking at monetary restraint to make sure inflation doesn’t become an issue.

China continues to forge ahead on its economic and market reforms at the same time it seems to be going in reverse politically. Numerous incremental changes have been made in the financial markets that all point to a more market-oriented approach to economic policy. A series of important domestic policy initiatives have been announced that will allow more individual economic freedom. However, censorship is as strong as ever and China is flexing its military and political muscle on regional territory issues, including most surprisingly Hong Kong.

Cautiously Overweight US Stocks, Aggressively Overweight Non US Stocks

In most portfolios, we hold the maximum weight permitted in international stocks, particularly smaller company stocks, as we believe valuations are more compelling and better growth lies ahead. We have increased our weightings in hedged equity and continue to be underweight in fixed income, with a relatively defensive stance within those holdings.

July 9, 2014