Economic Discussion A Review of the Economy and Financial Markets April 2015 The Economy and Politics Spring is starting to show itself in Michigan. Birds are singing and the snow is mostly melted. A harsh winter has relented. The U.S. economy is moving forward in the halting pattern seen over the past several years. The winter of 2014-2015 was not as severe as that of 2013-2014, but January and February were pretty bad, nevertheless. There are signs of economic re-awakening amidst disappointing reports. In the first week of April there was a promising report on automobile sales but the March employment report was worse than anticipated. As was noted last month, economic growth seems to be taking hold in most of the developed world, but it is not robust. The euro area is expected to grow less than 2% annually over the next couple of years. Japan’s economy is expected to grow 1% in 2015 following 2014 in which there was no growth. In recent days their inflation appeared to be near zero despite months of attempts to weaken the currency in hopes of generating inflation. The United Kingdom and the United States are the strongest developed economies with growth projected at or near 3%. Emerging economies are likely to show more growth, but the rates vary widely. Russia will contract this year while China will grow about 7%. Overall the BRIC’s1 are expected to grow at about 4.75%.2 a nice way of saying, “don’t run deficits.” It means raising taxes and/or cutting spending. Neither is palatable to the citizenry. Unfortunately, fiscal policy gets much less attention. The exception would be the Greek situation. That nation is virtually out of money and must borrow to rollover maturing debt. Other European nations, notably Germany, have demanded structural (i.e. fiscal) reforms. The recently elected Greek government has balked, saying that the people are tired of austerity. (Let’s face it. Nobody likes austerity.) It would seem that fiscal matters don’t get addressed seriously until an economy is at crisis stage. A recent article in The Economist focuses how pension promises are standing in the way of progress in resolving Greece’s fiscal problem. The foregoing estimates are less than anyone would like. Central banks throughout the developed world are using some form of quantitative easing (i.e. expansive money supply growth) to stimulate growth and to generate inflation. Most have a target of 2% inflation. The problem is that monetary tools are being employed exclusively. Structural changes are needed. That is the province of fiscal policy. Structural changes are The Review of the Economy and Financial Markets, presented by Chemical Bank, is a publication based on resources such as statistical services and industry communications which we believe to be reliable but are not represented as accurate or complete and therefore cannot be guaranteed. Any opinions expressed in this publication may change at any time without notice. Based upon varying considerations, the management of individual accounts by Chemical Bank may differ from any recommendations herein. This report is provided for informational purposes only and does not constitute a recommendation to purchase or sell any security or commodity. Chart I Review of the Economy and Financial Markets April 2015 Economic growth will be constrained until fiscal reforms are addressed around the world. Addressing them early is better than late. The United States is a prime example of a nation that has time to implement reforms without entering another financial crisis. Unfortunately there seems to be little will to tackle the chore. The Congressional Budget Office (CBO) projects fiscal deficits every year through 2025, the end of their forecast period.6 Tax reform efforts are talked about, but left in the committee room. Congressman Dave Camp’s efforts got out of committee but no further. The magazine notes that Greece spends 17.5% of GDP on pensions compared to 12.3% in Germany. Another angle on this phenomenon is how many 55-64 year olds are employed. The foregoing chart shows percentages for several countries.3 Early retirements, if not fully funded, place a burden on those still working. Unfunded pension liabilities don’t show up on traditional debt statements. The fiscal problems in many U.S. cities and states have resulted from generous pensions and retirement terms. In the U.S., promised Social Security benefits are a looming problem. A first step in reducing the burden is increasing retirement ages, but doing so is a political problem. The significance to investors is that economic growth will be less than it could have been throughout the developed world. Markets will be volatile and, ultimately, some creditors will take losses. Greece has other problems: a culture of corruption and a high level of tax evasion among them. Still its delay in addressing generous early retirement ages should serve as an example to other countries. The Federal Open Market Committee (FOMC) is focused on employment and inflation. That’s logical since Congress has charged them with maximizing employment and price stability. On March 18th they held the overnight bank lending rate (the fed funds rate) in the 0%-0.25% range and said that a change at the April meeting was unlikely. Fiscal deficits are the norm throughout the developed world. Of the 34 advanced economies tallied in the International Monetary Fund’s Fiscal Monitor, only 7 show projected fiscal surpluses for 2015. Gross government debt for that group averages 106% of GDP.4 To state the obvious, total debt accumulates from annual fiscal deficits. In March the unemployment rate was unchanged at 5.5%. The Consumer Price Index (CPI) was flat for the year ended February 28th. Excluding food and energy prices, the CPI rose 1.7% over the same 12 month period. Earlier comments from FOMC officials led many to consider a 5% unemployment rate as being full employment. The FOMC has said their target for inflation is 2%. It must be assumed they consider that “price stability.” In previous months we have cited the work of Irving Fisher noting that debt reduction is a precondition to recovery from depressions. His work was done in the first half of the twentieth century, particularly following the Great Depression. In recent years Carmen Reinhart and Kenneth Rogoff have written extensively on the effect of debt overhang following financial crises. Where Fisher focused on private debt, Reinhart and Rogoff included government debt in their analyses. In a December 2013 paper they argue that developed economies as well as emerging economies need to perform debt restructuring in order to emerge from financial crises and deep recessions. Debt sustainability cannot be achieved, they argue, only through austerity, forbearance and growth. Even for developed nations, there must be debt restructuring or forgiveness in some form.5 Massive infusions of money into the U.S. economy over the past few years has driven annual growth to barely more than 2%. The historical average is about 3%. It would seem that explosive money growth would generate inflation, but that hasn’t happened. By definition, the velocity of money has been low for several years. It once was thought to be constant, deviating from normal levels for only short time periods. The lower level of money velocity indicates reluctance by businesses and individuals to make long-term investment commitments. Less complicated tax schemes and a more constructive regulatory approach Page 2 Review of the Economy and Financial Markets April 2015 would seem near. The committee has said that future moves will be guided by economic developments. would encourage investment. In the U.S. real GDP has grown at just over 2% in recent years. See Chart II which follows. Even modest economic growth should increase credit demand, thus increasing interest rates. The upward movement is not likely to be steady any more than the path down was straight. See Chart III which traces the yield of the ten-year Treasury note for the past eight years. Chart II Growth has averaged 2.2% since the economy emerged from recession in late 2009. The red line shows a slight upward trend. The initial estimate of first quarter growth will be released later in April. Already estimates are being scaled downward in response to the weak employment report. The shortfall is being attributed to harsh winter weather. There could be a “snap-back” reaction in the second quarter. Time will tell. Our estimates for 2015 growth are on the conservative side. In 2015 the U.S. economy is likely to grow between 2.50% and 2.75%. Inflation, as measured by the CPI, will likely be 1.25%. Chart III It would appear that bond yields don’t correlate very well with anything! The yield followed a jagged downward path after growth resumed in 2009 until mid-2013 when the FOMC announced that they would be phasing out their third stage of quantitative easing. Rates popped up initially, then tapered downward as the FOMC actually did phase out the bond buying program. Through this time there were other factors impacting rates: turmoil in the Middle East, the Russian takeover of Crimea, the plunge in the price of oil and a weak global economy. All of these factors contributed to a strong U.S. dollar which amplified the effect of the factors themselves. Financial Markets and Interest Rates Financial markets are obsessed with the timing of the FOMC’s movement to a less accommodative policy. With inflation and unemployment so close to presumed targets, the change in policy Page 3 Review of the Economy and Financial Markets April 2015 developed foreign stocks (red line) and the MSCI Emerging Market index (gray line). All three indices have had positive total returns over the time period. U.S. stocks outstripped the others because of relatively better economic performance and a stronger currency. Whether it’s intrepid or foolhardy, we will try to give guidance as to the future course of rates. Longer term rates will increase over the next two years. The ten-year Treasury yield, now at 1.90%, is likely to be 2.60% at the end of 2015 and 3.40% at the end of 2016. The fed funds rate now 0.13% is expected to begin to rise in the summer of 2015 reaching 0.50% at the end of the year. At the end of 2016 it is likely to be 1.60%. Our best guess for the “normal” level is 3.75%. Investors are always faced with the dilemma of balancing risk and return. Why would an investor ever buy a security that has a lower expected return than another? The answer is that the lower returning asset is less risky. That may seem obvious, but investors sometime forget that fundamental principal. At the present time (and for the last several years) the safest securities, bonds, have provided miserably low yields. It is interesting that out of ten asset classes, U.S. bonds ranked fourth for total return in 2014.7 Rates declined through 2014 so bond prices appreciated. The FOMC released the rate expectations of the seventeen members after the March meeting. Most expect the fed funds rate to be 0.50% at the end of 2015. The guesses range from 0.0% to 1.5%. The longer run rate level expected by most of them is 3.50% to 3.75%. The range is 3% to 4.25%. Our expectations for the time periods are close to the majority of the FOMC members. Stock markets have had a good run over the past three years, with the exception of emerging market issues. This is shown in Chart IV. Let’s take a moment and review basic portfolio management principles. There is little question that stocks, over time, will provide greater returns than bonds. Investors can’t always wait forever. Portfolio strategy must be predicated on a balance of asset classes that reflects the time horizon of the investor and that investor’s risk tolerance. Risk tolerance reflects the level of the investor’s wealth and tendency toward nervousness. Presently, stocks have the potential to produce greater returns than bonds by what seems a large margin. On a pure valuation basis domestic stocks have had a strong run and are reaching fair value, developed foreign stocks are most attractive and emerging market equities are reasonably valued. There are global political issues that, for a time, may override the pure valuation analyses. Domestic stocks can remain as an over-weighted category a bit longer. Political issues in Europe have to become more settled before their stock markets reflect the good valuation levels. The fallout of a slower global economy on emerging equities is not yet known. Chart IV At the present time appropriate asset allocation would be: domestic stocks at or slightly above an account’s mid-point, foreign developed at or slightly below the mid-point and emerging markets stocks at the The chart tracks the S&P 500 (black line), the MSCI EAFE Index of Page 4 Review of the Economy and Financial Markets April 2015 mid-point. Overall, stocks should be modestly over-weighted. Bonds, consequently, should be modestly underweighted. Because of the expectation that interest rates will slowly increase over the next couple of years, long maturity bonds should be avoided. Maturities should be spread over the two-to-five year range. Actively traded bond portfolios could benefit from a portion of the portfolio being as far out as seven years. Cash equivalents and very short term bonds should be held only to cover anticipated liquidity demands. We have already noted a high level of economic uncertainty around the world and the potential for higher volatility in financial markets. In such an environment, a disciplined approach to asset allocation takes on added importance. Portfolio allocations should be reviewed on a regular basis and imbalances corrected more promptly than would be necessary in a more stable time. April 11, 2015 wcl 1 BRICS is an acronym for Brazil, Russia, India, China and South Africa. As a group they are thought to be representative of emerging economies as a whole. 2 Estimates of growth are based on a consensus of a Bloomberg Finance, LP panel. 3 The foregoing data and the chart are from The Economist, April 4, 2015. 4 Fiscal Monitor, International Monetary Fund, October 2014. 5 Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, Carmen M. Reinhart and Kenneth S. Rogoff, White Paper prepared for and distributed by the International Monetary Fund, December 2013. 6 An Analysis of the President’s 2016 Budget, The Congressional Budget Office, March 2016. 7 Original source, Zephyr Associates. Page 5
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