Three Key Thoughts:
Fed dials back its optimism about US economy; 2+% is the new norm
China's stock market volatility complicates market reformers' job
Greece is the word
Last quarter, we talked about our expectation that the US economy would grow in the 2-2.5% range for 2015, a result very similar to the previous three years. Now that we have seen much more data on the first quarter and some preliminary figures for the second quarter, the Federal Reserve has dialed its consensus forecasts down into this range as well. And the discussions about interest rate hikes are more about the Fed wanting to get off of zero so that it has room to maneuver if the economy weakens. This is a very different viewpoint than one which had been concerned about strong growth and inflation.
You might wonder why we spend any time thinking about the aggregate growth of the US economy. After all, gyrations in that growth rate show very little correlation to stock market returns. We care because stock prices are tied quite closely to corporate earnings and aggregate corporate earnings growth is tied to the nominal growth (not adjusted for inflation) in the economy. Stock prices can rise for either of two reasons: (1) growth in corporate earnings; or (2) an expansion in the multiple (the price/earnings ratio) that investors are willing to pay for future earnings. At this point in the market cycle, those multiples have already expanded significantly so further gains are very dependent on earnings growth.
There are other underlying reasons why we expect the economy to grow slowly over the next several years. In aggregate, the economy can only produce more by a combination of increases in the labor force and increases in productivity. The Bureau of Labor Statistics projects that the US labor force will grow by about 0.5% over the next 7 years. With the exception of a short period in the early 2000s, productivity has increased about 1.5% annually over the long term. Adding these together, we get about 2% real (after inflation) growth as the new benchmark. If we add 2% inflation, then we can expect about 4% in corporate profit growth, certainly not a very exciting number.
With the US stock market trading at a price/earnings ratio of about 17, investors are paying a relatively high price for pretty slow growth. So what is a good corporate executive to do? Predictably, corporations have been raising dividends and buying back stock. While stock buybacks boost reported earnings per share (because the share count is lower), they do nothing to grow the underlying business. Bottom line: we expect modest returns on US stocks.
Outside the US, we are more optimistic about stocks as earnings growth is picking up in many places and prices are much more reasonable. However, the major non US economies all have their issues.
In China, financial regulators are getting a lesson in what can go wrong when markets are opened up without all of the proper regulatory controls in place. The China A share market soared for more than a year and now is suffering a severe correction. Day to day volatility is through the roof and regulators are scrambling to put in place proper margin account controls and other initiatives to stabilize the markets. Ironically, this stock market volatility was caused by the rush of domestic investors speculating on A shares, betting that prices would go higher once non US investors are fully allowed in. This game was bound to end poorly and it is a distraction from the government’s long term efforts to open China’s capital markets to the outside world. We view these developments as growing pains and, as in the past, China will learn, adapt and move forward.
Japan continues to make progress, albeit slowly, in creating sustainable economic growth and a moderate level of inflation. If we look at Japan with the same lens we examined US growth potential above, it is easy to see how difficult their challenge is. Japan’s demographics are poor (rapidly aging and low birth rate) and they do not encourage immigration so their labor force is not growing. Addressing these issues is one part of Prime Minister Abe’s “third arrow” of comprehensive labor and corporate governance reforms.
In Europe, Greece is the word, for now anyway. Having stolen the limelight from the rest of Europe (which seemed on the road to a respectable recovery), Greece now seems to be playing the part of your erratic drunk uncle at the family party. His behavior gets increasingly bizarre up to the point at which he is ushered out the door by the largest family members. It seems to us that the only reasons the Europeans continue to negotiate are: (1) to prevent other weak members (Portugal, Spain, Italy and France) from trying to renegotiate their own debts; and (2) to prevent Greece from leaving the Eurozone and providing an opening for a competing rescue with geopolitical implications (think Russia). If the Europeans could dispatch Greece in isolation, they would have long since done so. It is just not that simple and the entire episode raises questions about the wisdom of the currency union for weaker members. So we must be mindful of the broader risks and how they are managed.
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 except in closed end funds where discounts to net asset value have widened to very attractive levels. We continue to add to carefully selected hedged strategies as a way of controlling portfolio risk.
July 8, 2015 © Essential Investment Partners, LLC All Rights Reserved