Let it Grow
After a six-month-long period of generally weakening global data, we are watching for signs that those trends are about to turn. Although our fundamental conditions barometer has yet to turn, very recent indications seem to be hinting at the possibility of a pickup in growth.
Having an unbiased method for tracking changes in fundamental conditions helps keep us on our toes and responsive to changes in conditions that have the ability to impact returns. Although equity indices are near highs, a broader look at the data led us to reduce expectations through the back half of 2014 and into the first part of 2015. Yes, we see that the major equity indices in the United States sit near record highs. Yes, we see there is continued progress on employment. Yes, there is evidence that production continues to expand here at home. So why is it that our technical indicators told us a different story since summer’s end?
Much of the explanation stems from weaker performance abroad. The expected growth path for Europe and China fell throughout 2014 as Europe and Latin America each grew less than 1%, Japan failed to grow at all, Russia slipped into recession, and China’s growth rate fell. By contrast, the United States grew by 2.4% (likely will be revised down, however, as recent data suggests slower Gross Domestic Product (GDP) through the fourth quarter). Still, we are not immune to happenings outside our borders. We live in an interconnected world after all.
Through most of the last six months, global growth came under pressure for a variety of reasons. Chinese manufacturing fell sharply, and industrial production was cut sharply in places like Brazil. Energy and industrial metal prices slid in response to slowing global growth. Financial conditions in Asia (ex-Japan) and Europe exhibited signs of increasing stress. Here in the United States, we saw corporate bond spreads widen relative to government bonds, long-term Treasury bonds significantly outperform stocks, long-run inflation expectations fall, productivity growth grind to a halt, and analyst forecasts for S&P 500 profits start to be cut. The dollar rose as global investors sought the perceived safety of U.S. assets and potential for better relative returns here in the United States. However, there is some question in our minds that if weakening global economic trends were to continue unabated into 2016, the prospects for growth even here would be called into question. Hence, we are again at a critical inflection point.
And what about the Federal Reserve Bank (Fed)? Shouldn’t they be concerned about falling inflation expectations, widening credit spreads, a flattening yield curve, an underperforming stock market (vs. Treasuries), and a sharply rising dollar? Shouldn’t this raise red flags at the Fed and cause them to signal they are willing to hold off raising rates? Ben Bernanke used to look at these factors when assessing the market’s opinion of Fed policy and these same indicators today seem to point directionally toward continued monetary easing instead of tightening. It must be that the Fed believes that trends will improve from here, and maybe they will. After all, it makes sense that:
- low energy prices should enliven consumption;
- real wage growth should boost unit volumes;
- low interest rates will spur borrowing;
- the slide in the Euro will give that region at least a temporary reprieve from deflation and boost exports; and
- a round of emerging market rate cuts will enliven growth in those beleaguered economies.
All of these seem like reasonable expectations and represent the “bull case” for growth.
There may be some more good news to report. In the last dozen or so trading sessions, credit spreads have stopped widening, the oil price seems to be finding a floor, inflation breakeven rates in the TIPS market are up slightly, and some of the data from Europe is looking a bit better (for example, German and French business confidence improved modestly last month, fourth quarter Euro-area GDP was slightly better than expected, and European equity markets have been outperforming). Greece’s troubles are still worth watching as bond yields are still signaling concern, but there is some hope that negotiations will provide the liquidity that would allow Greece to avoid a messy default.
Meanwhile, stocks continue to enjoy a relative valuation advantage over Treasuries. The earnings yield for the S&P 500 is above 6%, with long-term Treasuries near 2%. So long as earnings remain strong and Treasury yields remain low, we would conclude that equities remain the better long-term bet. A sustained period of better news out of the global economy could be all that is needed to provide a catalyst for us to lift our short-term outlook. To that end, we will be looking for signs of movement toward a liquidity injection for Greece (we think this will eventually happen) and signs of a pickup in U.S. business investment when Thursday’s durable goods report is released.
Asset Allocation Portfolio Posture
LONG-RUN STRATEGIC POSTURE: Strategic allocations are set to reflect our long-run forecasts for key asset classes. We expect policy rates to remain low as central banks continue to push lower-for-longer rate strategies. Eventually, rates should rise back to more normal levels, but this is expected to happen gradually and unevenly. Fixed income returns are expected to lag current yields as rates rise. Equity returns will track moderate growth in global GDP, with little to no further lift from margin expansion (margins are already elevated). Equity valuations appear reasonable and in line with historic multiples, so no additional return is being attributed to margin expansion.