Weekly Economic Commentary • Principal Global Investors
Covering the week ended March 28, 2014 — Published on April 4, 2014
A Return to Normal
At an upscale local bistro in north Scottsdale, Arizona, it took an hour to get a table at 6:30 on a recent Saturday evening, the longest wait since before the financial crisis, and just one of many anecdotes suggesting the U.S. is getting back to normal and the business cycle is heading for maturity. Yes, first quarter growth will be slow from the arctic winds that blew a severe winter over the U.S., but the data is already rebounding as the big freeze thaws. Post Crisis Relapse Disorder, (PCRD) where one wakes every morning thinking there's still a recession, is fading as the financial crisis is farther in the rearview mirror. Pent-up demand should emerge for the small and large luxuries that were eliminated during the rush to deleverage: autos, housing, eating out, leisure activities, and vacations.
As normalcy returns, the business cycle will look more familiar as it begins to point toward maturity. Newer data looks mid-cycle or beyond: commercial and industrial loans have started to surge at the fastest pace of the expansion as capital spending prepares to ramp up; consumer confidence is rebounding with the Conference Board index the best since early 2008; regional PMIs are bouncing back and two show robust investment plans; fourth quarter GDP was revised up to 2.6%; state coincident indicators are healthy and tax revenue is surging; wage growth is picking up; industrial production is strong; jobless claims are near the lowest since before the recession; plans to buy vacuum cleaners and houses are back to average levels; corporate profits rose 8% last year; and the number of residential foreclosures fell back to 2005 to 2006 levels.
Expansion aging: By the end of June, the U.S. expansion will be 5 years old and likely at or past the mid-summer of the business cycle and heading into fall. The Fed is already starting to think about normalizing interest rates (see below), but action to do so is well into next year. Our forecast (at the end of the commentary) is for above 3% growth the rest of 2014 and further solid progress in next year's first half. There could be market disruptions and slower growth as investors begin to anticipate the Fed's initial steps to remove its extraordinary policy accommodation next year.
At some point as the expansion ages, it will behoove investors to watch for typical signs of excess, distress, and imbalances that usually build in the later stages of an economic expansion; they are often a prelude to the next recession. None of those indications or harbingers is the least bit visible now. So, unless provoked by an unexpected geopolitical problem, the winter of the business cycle, that next recession, is likely some way into the future. Selected forecasts are shown in Exhibit I.
A — Actual E — Estimated
Sources: Bloomberg, Barclays Capital Live.
A profound and secular shift is underway in the dynamics of global growth. Driven by free trade and industrialization in China, developing countries saw very fast growth and spectacular equity performance during the 2000s. That boom has faded and growth in China is slowing permanently for several reasons. First, China's labor force will begin to shrink, a result of the long-running one-child policy. Second, many of the underemployed workers have already moved off the farm and into factories, so productivity growth is surely past its peak. Finally, fast rising wages, moderate currency appreciation, and rising transportation costs have made manufacturing in China for export to developed countries much less competitive than a decade or two ago.
EM headwinds: As the economic boom matured, imbalances and excesses began to build and emerging markets now face structural headwinds: Profit growth has collapsed, squeezed by higher wages and no endproduct pricing power; inflation is too high; easy money from foreign investors led to years of fast credit growth and now credit stress and debt problems. As a result, growth has slowed in the emerging world and will not recover to the levels of the 2000s. A large cache of reserves and moderate stimulus should prevent a hard landing in China and thus keep the rest of the developing world growing at a reasonable pace in 2014.
Another headwind is that the commodity super-cycle has topped out. Induced by record high prices, producers have boosted output; increases in supply have caught up with growth-diminished gains in demand. Commodity prices will likely not exceed their recent inflation-adjusted peaks for a long time, putting pressure on commodity-exporting countries.
The upside, though, of fast wage growth, rising incomes, and a burgeoning middle class in China and developing countries is that households gain the wherewithal to buy the goods and services developed countries have for sale: fur-lined boots from Australia, Swiss watches, German cars, financial products from London, technology, consulting, and design services from the U.S. The pendulum that swung away from the United States and other developed countries for two decades is beginning to swing back.
Global decoupling: Another reason for these divergent trends is the timing of each region's financial crisis. The U.S. economy suffered the worst of the crunch in 2008 and 2009. Now, after almost five years of growth, most of the bad news is past; banks have been recapitalized, house prices have rebounded, and double-dip worries no longer crowd the headlines. Normalcy is returning.
The Eurozone encountered the most severe part of its sovereign debt disaster in 2011 and 2012. So, the area is just coming out of its recession in the last couple of quarters. Growth is fragile, banks are barely recovering, lending standards stay high, credit is less available, and deflation and relapse worries still abound. Progress has been made: Unit labor costs have fallen in much of the debt-laden periphery; government budgets are in better shape; and there is less political uncertainty.
China is even later in the process. After 30 years of breakneck, investment and export-led, commodity-centric 10% growth, the boom slowed markedly during the global financial crisis. But, a huge policy-sponsored, credit-driven stimulus began in late 2008, revving up the economy again. Policy was tightened in 2011 and 2012 leading to an economic slowdown in 2013. Financial stress from the excess credit is now appearing in the form of plunging profits and defaults. So, the real slowdown may be yet to come.
Global economic trends are diverging. Developed countries will be key drivers of the world economic engine as emerging nations face headwinds.
When Is Bad News Good?
When it forces officials to ease policy. The Markit PMI for China in March hit the lowest level in eight months at 48.1 rather than rebounding post-New Year as typical. That weak report was enough to reignite hope for stimulus. Xinhua, the official Chinese news agency, reported that Premier Li stated the government had policies available to combat economic volatility. It will likely accelerate planned construction projects, improve urban housing, and implement reforms set out in the March 5 parliamentary meeting. For now, the government is unlikely to mount any big new stimulus projects.
Indicators of financial stress continue to pop up in China. Last week, the Financial Times reported a run at a small rural bank, Jiangsu Sheyang Rural Commercial Bank. The trouble started on Monday but by Wednesday the government intervened. The bank manages RMB12 billion of assets, only 0.01% of total banking system assets, but it highlights China's lack of deposit insurance. Depositors instead rely on implicit government backing. Regulators are expected to roll out formal deposit insurance in the coming months.
European deflation threat: Markets also reacted positively to negative news from Europe last week. Weak March inflation numbers raised investor hopes the ECB would begin new stimulus measures at its next policy meeting. Spanish consumer prices unexpectedly dropped 0.2% year-over-year, the first decline since 2009. And German inflation dropped below 1% to 0.9%.
These inflation numbers were released after central bank heads from Finland and Germany openly discussed additional easing tools. In an interview with Market News, Jens Weidmann, Bundesbank head, stated the ECB could purchase either government bonds or private sector assets. In a Wall Street Journal interview, Bank of Finland Governor Liikanen discussed other tools the ECB has available including negative deposit rates, asset purchases, and bank lending. This is important since the Bundesbank and the Bank of Finland have been hesitant to allow bolder monetary policy; both now appear to be changing their tune. Those interviews and weak inflation numbers put pressure on the ECB to further ease policy at its early April meeting. That could boost markets and economic growth.
In Japan: Household spending dropped 2.5% year-over-year last month as clothing and footwear sales dropped 9.2%. But purchases of durable goods soared 25.4% as households bought big ticket items ahead of the three percentage point sales tax hike in April. The core CPI, ex-food and energy, increased 0.8%, the most since 1998.
Japan needs a range of stimulus to offset the effect of the April tax hike — higher wages would help. Larger firms including Toyota, Nissan, Toshiba, Hitachi, and Panasonic supported higher wages in this spring's pay negotiations. However, few small businesses increased pay. The Japan Times cited the Shinkin Central Bank survey that showed only about 17% of small firms raised wages.
More fiscal and monetary stimulus would boost growth too and the government is prepared to do so. For example, Bloomberg reported that Japanese Finance Minister Aso stated that the government will spend 40% of its 2014-2015 fiscal year funds in the April to June quarter. Bloomberg also reported that Abe advisor Etsuro Honda thought that the Bank of Japan could ease more as early as mid-May, which would help lower the yen. Relative to the dollar, the yen has increased 3% this year after dropping in value 18% last year.
Conclusion: In China, the market is thinking the government will ease more to offset slowing growth. In Europe, the latest round of inflation data raised the odds the ECB would move toward quantitative easing (QE) or negative deposit rates. Investors are waiting to see whether the government and central bank will do what it takes to offset the fiscal drag from the April tax hike.
Fed Policy: Rules or Discretion?
Discretion, of course; who wants to be confined by rules? At its March meeting, the Fed answered a key question raised in January: How would the Fed guide investors about future policy? Clearly, such guidance will become more qualitative since the 6.5% unemployment rate benchmark of December 2012 was dropped. That was replaced with language about the broader job market; the only quantitative piece left is the Fed's 2% inflation guideline, plus the phrase "longer term inflation expectations remain well anchored." So, loosely tied to data, this new guidance is much less definitive and protects the Fed's discretionary prerogatives.
That change, combined with a more upbeat economic outlook and a willingness to attribute recent weak data to bad weather, suggested the Fed was preparing to raise the Fed Funds rate earlier than expected. Adding to the slightly more "hawkish" attitude was an offhand answer to a question at Fed Chair Yellen's first press conference; when asked to define "considerable period," she noted that, while the definition was fluid and dependent on incoming data, it could mean six months after the end of bond purchases. That was earlier than expected and caused some short term volatility in financial markets. While Treasury yields initially rose sharply, yields on ten-year bonds returned to their trading range, but two-year yields reached a new yearly high at 0.45%. Recent yield history is shown in Exhibit II.
*Based on the 10-year Treasury bond, over the prior 12 months.
The taper continues: If qualitative guidance and a hint of earlier rate hikes caught markets napping, the third $10 billion reduction in purchases did not. Unless growth collapses, further reductions are assured. With cuts of $10 billion per meeting, bond purchases will be down to $15 billion monthly by October. After that, QE3 will be history, just in time for Thanksgiving; U.S. investors will turn their attention to turkey, cranberry sauce, and timing the first hike in the Fed Funds rate.
The market volatility after the Fed meeting underscored investors' sensitivity to how the Fed frames its guidance. Had the taper pace been slowed, markets would raise an unwarranted concern about U.S. growth prospects. Conversely, a faster taper would have brought an expectation of even earlier rate hikes. The Fed wanted neither message. Nor did it intend to communicate that the job market had improved faster than anticipated. Yellen tried to clarify that the changes in forward guidance were only meant to suggest how policy evolves as the unemployment rate hits 6.5% and below. In her words, "The new guidance didn't represent any change in policy intentions, but instead reflects changes in the conditions we face." We project unemployment at 6.4% in May and 6.1% at year-end.
New Fed dots: faster growth, higher rates, flatter curve: Based on Federal Open Market Committee (FOMC) expectations, rate hikes are likely to be a little more aggressive than the "dots" suggested after the last meeting. The median expected Fed Funds rate at year-end 2015 is now 1.0%, one more hike than previously expected. And in the absence of adverse data, it may mean the first hike could occur earlier next year, perhaps even in the second quarter.
Clearly, the Fed is already starting to think about normalizing interest rates, but action to do so is still well into the future. By year-end, the purchase program will have ended, the first rate hike will be just months away, and the anchor on the short end of the yield curve will be steadily lightening, giving a flatter curve.
First quarter growth will be below 2.0%, depressed by a frigid winter. A spring bounce won't recoup all weather-related losses, but, the emergence of pent-up demand will be an important force for second quarter growth. If the jump in consumer spending is combined with a noticeable pickup in job growth, more housing activity, an end to public sector drag, higher exports, and rising capital spending, we'll have 3.0% plus growth the rest of 2014. This progress and an anticipation of a fading of extraordinary policy accommodation should put interest rates in a clear uptrend by year-end. Our yield forecasts are as follows:
|Federal Funds Target||0.00-0.25%||0.50-0.75%|
|2-year Treasury Rate||1.00%||1.75%|
|10-year Treasury Rate||3.50%||3.75%|
|2-10 year spread||2.50%||2.00%|
Political upheaval and safe havens: Besides slow growth this quarter, yields on U.S. Treasurys and other safe haven bonds are likely being pressured by geopolitical risks around Russia's annexation of Crimea. Investors cannot discern Russia's ultimate intentions for Ukraine or adjacent regions of Eastern Europe, so the push into safer sovereign bonds is holding down yields. Further, the Fed's new approach to forward guidance is subject to a much wider range of interpretations. So, investors will be sensitive to data flow and Fed commentary until the economy has time to shake off the bad weather effect. Until then and while political tensions remain high, ten-year Treasury yields could stay in their recent trading range around 2.75%.
Asset Allocation Corner: Is Flat the New Up?
Equity investors could be forgiven for thinking so after a collapse in January, rebound in February, and little gain in March. At the end of 2013 with a 30% plus total return for U.S. stocks in the bag, investors were optimistic, perhaps rightfully, about further gains in early 2014. That hope and confidence for the quarter has not been fulfilled. U.S. returns were barely positive; Japan way underperformed with Morgan Stanley Capital International (MSCI) Japan off -9.5%; peripheral Europe had nice gains, but MSCI Europe rose less than 1%.
The MSCI All Country World index ticked down -0.15% and the MSCI Developed World index was flat for the quarter. Both indices fell a bit in March, down -0.5% and -0.8% respectively. The meltdown in emerging markets in January after ten-year U.S. Treasury yields hit 3% at year-end draining needed liquidity was stopped and followed by nice gains. The MSCI Emerging index fell 1.8% for the quarter but after a -6.6% plunge in January, followed by recoils of 3.2% and 1.9% in February and so far in March respectively.
U.S. and global REITs came back strongly in the quarter as interest rates fell from cycle highs, with MSCI indices up 8.1% and 5.6%, respectively after ticking down in March. Investors in peripheral Eurozone fared much better than those with global portfolios for the quarter; indices in Portugal, Greece, and Italy rose in the low teens with a key Irish index jumping 10.0%.
Bonds little different: Investors in U.S. and global bonds also had a flat March. However, returns were solidly positive for the quarter as interest rates came down from cycle highs, emerging market debt rebounded nicely, and the Bundesbank commented positively about more monetary easing. The political uncertainty surrounding Russia's actions in Ukraine has kept yields under pressure this month.
Commodities gain: We noted above our long-held view that the commodity super-cycle of one record price after another over the last decade plus had come to an end. China's ultra-fast growth and industrialization was fading and suppliers had upped their production to meet demand that was already slipping. And in general, commodity prices have come way off their cycle highs. But after that big downturn, there certainly is room for a cyclical move higher in commodities as growth in developed economies comes back and emerging market economies continue to expand, albeit at a slower rate. That is already happening; prices of several grains are up low double digits and the Commodity Research Bureau (CRB) index of raw industrials gained 1.2% for the quarter. The exceptions are copper, coal, and iron ore: commodities that have been used in China as collateral for loans; financial stress has pushed some supplies onto the market, cratering prices.
Asset Allocation Corner: What's an Investor to Do?
Stick with the program, a mild overweight for equities versus bonds, at least through a good share of this year. The current consolidation should meld into a modest uptrend into the spring and summer. To have a decent year for equity returns, though, the U.S. economy has to rebound from its winter freeze and the pressure on China and emerging markets must subside. Except for possible geopolitical problems, we believe both are likely.
How the cycle works: In our view, the most rewarding asset allocation depends critically on an estimate of where we are in the business cycle. If the economy did not have cycles, there would be no reason to change the shape of one's portfolio. Changes in business cycles are reflected in markets through fluctuations in investors' perceptions of risk. As a recession gets going, uncertainty and fear of disaster push investors into safe havens and out of risky assets. Later, as the recession winds down and a few investors smell recovery, selling pressure fades and the riskiest assets soar higher out of what was a bottomless pit of despair: e.g., distressed bonds, deep value stocks, and foreclosed property. Fears of a double-dip or further disaster gradually fade and confidence comes back turning to optimism over time. As the expansion matures, enthusiasm can get too high and lead to overheating, excess credit, and bubbles. As the bubble bursts, the downside returns and the cycle is set in motion once again.
Where in the cycle? After five years of a U.S. recovery, spring is clearly behind us; so we're likely in midsummer with fall perhaps coming shortly into view. Skepticism has grown over the quarter and replaced the excessive optimism at the end of 2013. There are few signs of imbalances, overheating, or excess in developed countries, so, we don't see a recession winter in the picture yet at all.
However, because of the very slow recovery, the extreme and ongoing monetary accommodation plus the long-lasting dread of relapse and fear of a doubledip among investors, the financial cycle may be more advanced than the economic one. So, we are surely well past the low in interest rates and believe U.S. Treasury yields will resume a modest uptrend: better rates for savers, not so good for current holders of long-dated bonds. This also suggests that credit spreads are at or approaching the narrows of the cycle. But since corporate defaults are not likely to expand for some time, investors taking credit risk should see better rewards than with duration risk.
The rally turns 5: An economic mid-summer but an autumn for markets suggests the stock market rally that turned 5 years old in early March is aging. Oft times, equity bull runs end in a big surge of a year or so as in 1999 or mid-2006 to mid-2007. The real bears might say this rally will fade after the 30% plus gusher of last year. But, we think there's more left as long as the U.S. economy meets improved forecasts and the pressure on emerging markets lessens. If that pans out, profits should grow in the 6% to 8% range. With a couple of points for dividends, total returns could be 8% to 12%, decent but not spectacular.
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