Highlights:
- Brinkmanship between the Greek government and its creditors risks undermining the economic recovery that has finally taken hold in many European countries.
- The Fed continues to take a cautious approach with regards to raising its benchmark short-term interest rate. There are several strengthening economic indicators that point to the first such rate increase later this year.
- The U.S. housing market continues to recover at a snail's pace and generally remains a drag on the economic recovery.
- Chinese equity markets have soared over the last several months, but have recently given much of that gain back as economic growth continues to slow and stimulus measures alone seem hard pressed to support current equity valuations.
- Monetary policies implemented by the Bank of Japan have been stymied by the fall in oil prices and declining consumer consumption that followed an increase in their national sales tax.
Commentary:
The showdown between Greece and its fellow eurozone country members seemingly came to a long awaited head during the quarter. After months of failed negotiations, the European Central Bank (ECB), International Monetary Fund (IMF) and the European Union indicated they would no longer serve as a safeguard between Greece and its lenders. This forced Greece to take the emergency steps of closing its banks and implementing capital controls to avert the collapse of its financial system. The Greeks then held a referendum to determine if they would accept the austerity measures demanded by its creditors or default on it’s debt, which many economists believe would be a prelude to it’s departure from the eurozone. The Greeks’ resounding “no” vote against further austerity measures, which were a condition for a new bailout package from its creditors, leave both Greece and the eurozone in uncharted waters.
If Greece were a company it would declare bankruptcy and reorganize its debt in exchange for much-needed reforms. Unfortunately, decisions are being driven by political rather than economic motivations. Greece’s creditors, other eurozone members and the IMF all want Greece to implement budget cuts, mostly via pension and sales tax increases. These cost-cutting measures, while likely needed to put Greece on a sustainable long-term path to financial stability, put the Greek people in the unenviable position of having to choose between accepting the reform measures mandated by its creditors or risking exit from the eurozone.
While there is little question that Greece needs the bailout money to stay afloat, it seems to be leveraging the potential upheaval its exit from the eurozone would have on global financial markets and the political consequences leaders of the other eurozone countries would face if they allowed Greece’s exit. Greece isn’t big enough that its departure alone would have a lasting impact on the eurozone. Its GDP is approximately 2% of Europe’s GDP and only 0.3% of global GDP. Rather it is the the fear that a precedent is being set that has caused anxiety among both political leaders and investors. The eurozone would hardly skip a beat should Greek determine to exit, but the same could not be said if in the future a larger country, such as Spain or Italy, were to leave the eurozone.
In the face of the recent “no” vote against further austerity measures, the risk of Greece exiting the Euro has increased, but fortunately evidence of contagion elsewhere has thus far been limited. This is likely because, unlike years ago when most of Greece’s debt was held by the private sector, this time around it is mostly held by the ECB and IMF, which can better absorb losses should Greek default. This reduces Greece’s leverage over creditors. Eurozone leaders are aware of the short-term risks in allowing Greece to exit, but are more concerned with maintaining the integrity of the euro. With many believing that Greece will be hard pressed to ever grow its economy enough to get out from its mountain of debt, the ECB, IMF and European Union seem reluctant to kick the proverbial can further down the road. Ultimately, while a Greece default and exit from the eurozone would be difficult for the Greek people in the short-term, it might offer the best chance stop an endless cycle of debt and provide a fresh start. The brinkmanship between Greece and its creditors promises to dominate headlines until a conclusion is reached.
Lost in the theatrics of the Greece showdown were signs that the stimulus measures enacted by the European Central Bank (ECB) earlier this year were showing signs of progress. Eurozone manufacturing and consumer prices both rose at their fastest pace in months, a healthy sign that the liquidity that the ECB is pumping in to its economy is yielding preliminary results. Nevertheless inflation remains well below the ECB’s target and the ECB stressed that the stimulus efforts would remain in place as long as needed until officials were confident they could maintain their inflation objective on a sustained basis. This rhetoric should sound familiar as it is almost identical to the what the U.S. Federal Reserve (the Fed) has been preaching for the last several years. While the ECB dragged its feet in implementing aggressive stimulus measures, it appears that it has finally gotten the message and is committed to doing whatever is necessary to stem deflationary threats and jumpstart its economy.
Speaking of the Fed, the June policy meeting came and went without the interest rate hike that many investors had expected earlier in the year. However, as the June meeting approached it became clear that the Fed would need to see more improvement in the labor market and be more confident that inflation would rise toward their 2% target before beginning to increase short-term rates. With the U.S. economy seemingly on firmer footing after a winter slump, it appears likely that the Fed will begin increasing interest rates later this year, albeit at a more gradual pace than first thought. The Fed’s most recent release indicated it might now raise rates only once in 2015 by a quarter percentage point rather than twice, as originally anticipated. Furthermore, the Fed now expects its benchmark short-term rate to remain below 3% at least until the end of 2017. This would be a far lower rate, historically, than previously seen this long in to an economic expansion.
There were several positive indicators of the improving health of the domestic economy that would seem to support the Fed increasing rates later this year. A recovery in gasoline prices caused consumer prices to tick up, suggesting that inflation might begin to stabilize. After tightening their belts during the winter, American consumers opened their wallets during the spring as retail sales surged at retail stores and restaurants. Healthier labor markets, as evidenced by an unemployment rate that is at pre-recession levels and a record number of job openings, could finally begin to put upward pressure on wage growth as firms compete to attract workers from other firms or occupations. If this wage growth did take hold, it would put additional money in consumers pockets that would hopefully keep them spending for the rest of the year and reverse the trend of consumer savings outweighing spending as U.S. households remain focused on shoring up their balance sheets. Capital investments by U.S. companies also finally began to show signs of picking up after one of its worst stretches since the recession of 2008.
The U.S. housing market continues to thaw, but generally remains a drag on the economic recovery. While home building has picked up considerably over the last several months, the scars from the housing crash continue to leave many current homeowners with little to no equity in their homes. This tends to make people feel tethered to their homes and reduces labor mobility that is important in a healthy economy. Millennials, weighed down by heavy student loan burdens and lackluster job prospects, have also limited the recovery in the housing market. Economists believe that many Millennials have delayed home ownership, not ruled it out altogether, and that demand from this group could be a boon to the housing market in the coming years. Apartment rents that are at record highs, and that show no sign of cooling down, may provide additional incentive for this group to consider home ownership, although they will likely encounter higher mortgage rates than those seen over the last several years. The continued recovery in this sector would help to balance the scales between consumer savings and spending as the wealth effect homeowners feel when they have equity in their homes generally leads to increased levels of discretionary spending.
Turning to the Far East, the Chinese equity markets have soared over the last twelve months. This has been primarily driven by the establishment of two-way stock-market access between Mainland China and Hong Kong and monetary stimulus policies that was enacted to combat a substantial local government debt problem and slumping real estate market. While recent reports have shown that the easing moves have had moderate success in reviving economic growth, these measures alone will be hard-pressed to maintain growth levels seen over the last several decades. It is therefore most probably the case that earnings amongst Chinese corporations will need to be robust in order to maintain equity market valuations at current levels. Already this week we have seen China’s equity market give back much of the significant run up it has seen over the last several months. Despite the struggle with growth that China’s economy is currently and will likely continue experiencing, the long-term growth potential of Chinese equity markets remains one of the most promising outside of frontier markets.
The fall in oil prices and declining domestic consumption levels that followed an increase in the national sales tax a year ago, continue to create headwinds that challenge the Bank of Japan’s attempts to reverse decades of deflation. With inflation levels hovering near zero and far from the BOJ’s target of 2%, it is fair to question if the BOJ will begin to move beyond it’s core strategy of monetary policy before they turn to fiscal policy measures. And if the BOJ does turn to fiscal policy measures, will they be able to effectively help the government deal with its debt problem in a manner that minimizes spending cuts and/or tax increases that could jeopardize the economic recovery?
While we make no attempts at forecasting what impact current economic conditions will have on future equity market returns, it is fair to conclude that central banks continue to play a large role in the global economy and financial markets as they have since the financial crisis of 2008. Despite years of economic recovery, however modest and uneven they have been in many parts of the world, investors still seem to look to the actions of the central banks for direction. The Fed has made it clear that it does not want to disrupt the economic recovery and will move slowly if and when it begins to tighten the belt on the loose monetary policies that have helped to propel and sustain the economic recovery. The period of interest rate normalization that will begin when the Fed does finally begin to raise rates is likely to produce volatile equity markets similar to the “taper tantrum” that we experienced two summers ago when many investors braced for rate increases.
While volatile equity markets are never pleasant, in this case rising rates would be a sign of a healthier economy and we have a hard time seeing how this won’t eventually benefit long-term investors. We continue to believe that the best strategy for equity investment is to insulate your portfolio with sufficient levels of cash and fixed income positions to be able to withstand such volatile periods without having to reduce equity exposure at undesirable times. An investment policy structured in this manner emphasizes time and diversification over timing and concentrated bets, allowing portfolios to weather situations such as we have seen in Greece and in China this quarter. With limited exposure to Chinese equities (approximately 2.9% over seven diversified international funds) and almost no exposure to Greek equities (approximately 0.02% in the Oakmark International Small Cap Fund), your risk and the immediate effects of these events to your portfolio should be limited. Such a policy remains the most efficient way to structure a portfolio in order to obtain a premium on one’s equity investments vis-à-vis a fixed income rate of return for prudent, long-term investors.
Urban Financial Advisory Corporation - July, 2015