Highlights:
- Facing strong deflationary headwinds, the European Central Bank (ECB) took a page from the U.S. Federal Reserve's (Fed) playbook and implemented a substantial bond-buying program.
- The Euro plummeted and U.S. dollar strengthened shortly after the ECB stimulus measures. This created both opportunities and headaches for many American companies. The Fed continues to weigh conflicting economic data in determining when it might begin to increase interest rates.
- After a prolonged period of economic growth, China's economy continues to cool off. China's central bank is contemplating more broad-based stimulus measures to spur economic activity.
- The Japanese stock market continues to reap the benefits of the Bank of Japan's ongoing stimulus measures, but bottom-line economic growth continues to be stuck in neutral.
Commentary:
The European Central Bank (ECB) finally launched a long-awaited stimulus program and the impact was almost immediately felt by both European and American companies alike. Elsewhere around the world, China continues to grapple with a slowing economy and Japan once again finds itself battling deflationary threats.
With Europe continuing to be faced with dormant growth, high debt and stalled labor markets, the ECB finally took decisive action with an aggressive bond-buying program. The ECB committed more than $1 trillion in newly created money by purchasing government bonds, which sparked a quarter-long rally in European equity markets and sent the Euro plunging. Lower interest rates have granted European companies access to cheap capital, and the tumbling Euro has resulted in increased demand for European goods from abroad. Nevertheless, these stimulus measures are not intended to cure all of Europe’s ills but rather to provide the structural reform necessary to create a foundation that eases deflationary pressures and stimulates growth.
The devalued Euro has been both a blessing and a curse for many American companies. On the positive side, U.S. multinational companies that have access to the European debt markets can borrow in Euros at significantly lower interest rates than they would have to pay at home. The surging dollar has also resulted in much of the rest of the world being on sale to U.S. corporations and consumers alike. Of course, this cuts both ways. The strong dollar has also made American products more expensive in global markets and made it more difficult for many American companies to compete abroad. It has also hurt overseas profits that are converted back to dollars by U.S. multinational corporations. These are two of the main reasons that many analysts have cut earnings forecasts of big U.S. multinationals, which resulted in developed international equity markets reversing course and outpacing their domestic equity market counterparts during the quarter.
Four factors have created uncertainty inside the Federal Reserve regarding interest rate hikes:
1. Slowing exports that have pinched U.S. factories and led to a big drop in industrial output;
2. A slowdown in U.S. hiring;
3. Tepid growth in consumer spending at retail stores with early reports showing that many consumers are directing savings at the pump to savings accounts and not shopping baskets;
4. An uninspiring home building report.
There was a time towards the end of 2014 and the beginning of 2015 that many investors anticipated that the Fed would begin raising rates at its June Meeting. This recent spate of weak economic data now has many investors questioning if the Fed will put interest-rate hikes in play at a time when other central banks around the world are moving to lower their interest rates and weaken their currencies to ward off soft growth and inflation.
The perplexing employment picture is likely to continue to be a major determinant in the timing of the Fed’s decision. The disconnect between falling unemployment and stagnant wages remains a headwind to the U.S. consumer. Although the unemployment rate, down to 5.5%, is technically back to normal, this rate does not include the untold number of workers who are no longer actively looking for work or who can only secure part-time employment. These “shadow unemployed” temper the bargaining power of current workers.
Nominal wage growth is likely also holding back the housing market. Even though mortgage rates continue to hover near all-time lows and there is strong pent-up demand, for most people, buying a home remains cost prohibitive. This is because home prices have increased at a significantly higher rate than wages. The recovery that has been seen in the housing market over the last couple of years has been driven in large part by institutional investors and international buyers who are not as constrained by incomes.
Whereas the Fed continues to contemplate how to wean the U.S. economy off of a steady diet of expansionary elixirs, China’s central bank faces the opposite problem. After decades of prolonged growth, China’s economy is now faced with waning growth and falling inflation. This has led to speculation that China’s central bank will follow in Europe’s footsteps and consider more broad-based measures to free up credit to spur economic activity. This would mark a change in course from previous policies that have focused on more targeted efforts that helped boost stock market returns and benefited industries that relied more on debt, but failed to boost overall consumer demand and consumption.
Lastly, the Bank of Japan (BOJ) continues to see mixed results from its ongoing stimulus measures. The three-pronged approached, coined “Abenomics” after Prime Minister Shinzo Abe, combines fiscal expansion, monetary easing and structural reform. Abenomics has been effective in pushing down interest rates, weakening the yen, putting upward pressure on higher wages for workers, and helping the Japanese stock market ascend to 15-year highs. The impact to date on the real economy has unfortunately been less impressive with gross domestic product growing at a snail’s pace of around 0.2% annually over the last couple of years and inflation still well below the 2% target set by the BOJ.
To conclude, our view of the current global economy is that there are many things that are worrisome. We also believe that this is usually and continually going to be the case. With many equity markets still hovering near all-time highs and the prospect of the Fed raising interest rates growing larger, it is reasonable to conclude that volatility in the equity markets is likely to persist. This is also nothing new. We remain steadfast in our view that a prudent investment policy is one that is driven by an objective process to determine appropriate cash and fixed income exposure representative of anticipated withdrawal requirements over the next several years. Engaging in this process of adequately insulating a portfolio results in identification of funds that are then appropriate for investment in a more volatile portfolio of diversified equities. Such a policy is grounded in its reliance on a long term approach and an avoidance of timing markets. It best positions an investor to participate in the capital appreciation propensity offered by global equity markets. We will leave you with this quote from Warren Buffet’s most recent shareholder letter of February 27, 2015 which we believe applies to many markets even beyond the U.S.:
“The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.”
Urban Financial Advisory Corporation - April, 2015