Failure to Communicate
A meeting between Euro-area finance ministers, central bankers, and European Commission officials ended abruptly Monday, as a Greek government official said the Euro area’s recommendation to extend bailout conditions was unacceptable. Greece’s current aid package expires February 28, thus necessitating a new round of negotiations between Greece and its creditors. The newly-elected Greek government is seeking a new deal with easier terms. The cost of Greek debt and the cost for bondholders to insure against a Greek default has risen dramatically in recent months, suggesting real concern about the potential for some form of default. Monday’s failed negotiation did little to calm investor anxieties.
Meanwhile, the data we review continues to be mixed. Growth in the United States seems to have weakened through the closing months of 2014. As a result of weaker indications on foreign trade, inventories, and retail sales, forecasts for fourth-quarter output have fallen sharply in recent weeks. Macroeconomic Advisers, a St. Louis based forecasting firm, cut its fourth quarter estimated Gross Domestic Product (GDP) growth rate to 1.8% from 3.4% in recent weeks, for example. Slower growth is being accompanied by a fall in productivity to near 0% in 2014, alongside negligible growth in the labor force. The combination of these two factors might explain some of the sharp drop in the unemployment rate we have seen in recent months.
This slowing has been accompanied by some flattening of the yield curve, as long-term bond yields have recently fallen to record lows. Corporate bond spreads have also widened in recent months, partly reflecting slower global growth, combined with concerns about plummeting oil prices. Forecast inflation priced into the bond market also slipped through the second part of 2014 and into 2015. Inflation priced into long-term Treasury Inflation Protected Securities now stands near 1.7% — well below levels seen last summer. These factors, along with signs of the weaker growth overseas, have led us to trim equity allocations.
We are hopeful that the dip in fundamental conditions will prove transitory. After all, wages are growing, household net worth has increased meaningfully, consumers are enjoying record-low interest rates, and oil prices have plunged by more than 50%. In addition, there are potential signs of improvement in Europe. Germany, for example, just posted an increase in gross domestic product of 2.8% for the fourth quarter of 2014, and there are tentative signs of improving industrial production in other countries. The fall in the Euro’s foreign exchange value is one potential catalyst for improvement in the months ahead.
We will be watching this week for new data on United States’ industrial production and minutes from the Federal Reserve from their January meeting. Both of these items will be released on Wednesday. Thursday will also bring an account of the European Central Bank’s January 22 meeting, at which it decided to start quantitative easing. This will be the first time the European Central Bank publishes a record of its monetary policy meetings.