The US economy grew by 2.3% in 2012, 2.2% in 2013 and 2.4% in 2014, despite a number of volatile quarterly reports. We expect a similar result in 2015. In fact, 2015 is shaping up in some ways very much like 2014: an unexpectedly poor first quarter, resulting from temporary factors, followed by a bounce back to somewhat stronger growth. The net result is slow but surprisingly consistent growth.
This time, the special factors have been the east coast weather (again!), the west coast port labor dispute and a sharp reduction in energy projects. In the last few weeks, we have seen expectations for first quarter growth get marked down quickly. Optimism for a second half rebound remains high, however.
The Federal Reserve seems to have become cheerleader-in-chief for the economy. Perhaps it isn’t too surprising that they would “talk their book,” hoping their optimism becomes contagious, allowing a move off of zero interest rates. Unfortunately, their track record in the last several years is consistent: too much optimism, which must be tempered significantly as reality sets in. Bond investors now believe the Fed will be slower to raise rates than the Fed members themselves believe. We agree.
While the economy will likely do better later this year, three factors will likely keep inflation low and growth slow: (1) the large decline in oil prices will keep headline inflation low and producer prices stable, offsetting modest wage pressures; (2) gains in the value of the dollar relative to almost all other major currencies make imports cheaper and exports more expensive, leading to lower domestic growth; (3) reduced capital expenditures and losses in high paying employment in the energy sector will be reflected in economic reports over the balance of 2015. Over the longer term, we believe that very slow growth in the labor force, combined with small productivity gains, will constrain our growth to less than 3%.
Over the next few weeks, we will get another read on the magnitude of the impact of the stronger dollar and lower oil prices on corporate earnings. In aggregate, earnings are likely to decline modestly. For now, investors are giving companies a pass on the earnings hit from the stronger dollar and are expecting that oil prices will gradually recover. And so far, consumers haven’t been spending their oil bonuses – they have been saving them instead. Put all these factors together and US stock valuations remain disturbingly high, relative to earnings.
Despite all of this talk about slow US growth, we are still doing much better than Europe and Japan. Looking back, the dollar strength compared to the Euro and the Yen makes perfect sense. Higher rates, stronger growth, low inflation: what’s not to like? The question is: where do we head from here? We believe that as the European and Japanese economies recover, the gap between the respective growth rates will decline and the currencies will be more stable. However, fixed income investors will continue to be drawn to US bonds as our rates are still more attractive than those available in Europe and Japan. We expect this will keep a lid on US longer term rates and the dollar in a positive trend.
Europe finally seems to be turning a corner, even while dealing with the Greek challenge and uncertainty in Ukraine. With the European Central Bank’s quantitative easing program well underway, we expect interest rates there to stay low until the major economies show sustained growth and some inflation is evident. These green shoots have been welcomed by the equity markets, which have rallied sharply. Unfortunately for US dollar investors, a portion of those gains have been erased by currency losses.
In Japan, the third arrow of Abenomics – important economic and labor reforms – are beginning to take hold. Corporate governance reform, increased equity investments by pension plans, greater employer/employee flexibility and growing wages are a few of the more visible signs that genuine change is afoot. Serious problems remain, however, including a very rapidly aging workforce, an aversion to immigration and low productivity growth, all of which work to limit the potential growth of the Japanese economy.
Finally, China continues on its unique path toward greater free market reform, broader social safety nets and crackdowns on political dissent and “corruption.” In the west, we have a hard time understanding how capitalism can flourish in the absence of political and personal freedom. Meanwhile, given the miraculous growth of the Chinese economy over the last 30 years, the Chinese wonder why we don’t think their model is better than ours!
We expect China to continue its move toward a sustainable 4-5% growth rate, suitable for a mature but healthy economy. And they have accelerated the pace of capital market reforms, including a more freely traded currency, more flexible exchange rate and relaxed constraints on trading in the domestic equity (A share) and Hong Kong equity markets. Longer term, this greater economic openness is quite positive for the entire region.
In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international stock markets where growth is emerging. In addition, we are under-weighted in fixed income as yields generally are not attractive. We continue to add to carefully selected hedged strategies as we believe valuations of US stocks and bonds are high.
April 15, 2015
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