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
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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
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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
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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
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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.
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