At Halftime, the Consumer Needs Water and Rest
June 30th marked the end of the second quarter and first half of 2015, a period in which the US equity market finished up marginally and the bond market was basically flat. These modest returns belie the extraordinary financial, economic, and geopolitical activity around the world since the beginning of the year. The debt crisis in Greece, decelerating economic growth in China, Puerto Rico’s debt crisis, negotiations with Iran over their nuclear program, and the rise of ISIS are among the issues that have weighed on the minds of investors in the first half of the year. While the US economy is showing continued gradual improvement, growth is nowhere near escape velocity, which is usually enjoyed by economies at this stage in a recovery. Moreover, high levels of debt in much of the world combined with generally unfavorable demographic trends are slowing global growth, setting the stage for continued challenges in the second half of the year.
The issue of slowing global growth is being addressed by central banks around the world, which have aggressively eased monetary policy overall. So far in 2015 twenty central banks have lowered interest rates while only a few, such as Brazil, Iceland, Turkey and Ukraine, have raised rates and have done so to bolster their currencies. The decelerating economic growth in China is reverberating throughout the world, which is reflected in depressed prices of industrial commodities such as copper, iron ore, oil, etc. While Japan and the Eurozone countries have shown some signs of economic growth, Japan is fighting the dual burdens of huge debt and an ultra-aging population. The Eurozone has its own debt challenges along with a common currency that is proving to be inflexible for troubled members. Among the developed countries, the economies of the US and UK have stabilized and are now growing, albeit slowly. However, the balance of the developed world and much of the emerging markets are struggling to generate and sustain economic growth. In our globalized economy it will be an increasing challenge for the US and UK to sustain their growth when so much of the world struggles to regain economic health.
Along with the concerns noted above that have weighed on investor minds, the financial world has been myopically focused on when the Yellen Fed will raise interest rates, as if on that particular day the financial and investment landscape will forever change. We know with relative certainty that when “liftoff” does occur the Fed will raise rates by 25 basis points, hardly noticeable in the big picture. Far more important will be the pace at which rates will rise over the next several months, which will remain as data dependent as the timing of the liftoff. The data upon which the Fed is most focused are the employment metrics and the rate of inflation. Of course, there are so many economic metrics released each week it is easy to get lost in an overwhelming amount of statistical data. Accordingly, focusing on the right things helps separate the wheat from the chaff.
It is most important to remember that the US economy is led by consumer spending, which from 1960-1981 represented approximately 62% of GDP, and has since risen to just over 70%. There are a lot of opinions as to how consumer spending is measured, what is included, and what real value-add it has to sustainable economic growth. However, there is little doubt that a financially healthy consumer is highly correlated with a strong and growing economy. Accordingly, a significant amount of energy is spent following unemployment, job creation, consumer sentiment, retail sales, etc., those things that either determine how much money will be in consumers’ pockets or track consumer spending. Retail sales have long been the measure of whether consumers are spending and after a very weak retail showing by consumers in the first quarter, there was a relatively healthy 2.7% annualized increase in the second quarter. However, given the weakness in Q1 many economists were hoping for a stronger snapback in Q2, which leaves in question consumer strength and/or their willingness to spend.
Further to the issue of consumer strength, seven years of zero bound interest rates and Fed bond buying have driven equity and bond markets to all-time highs, benefiting those lucky enough to own financial assets. However, the average worker upon whom we depend for economic growth is not among the lucky owners of stocks and bonds. Instead, the average worker is dependent on income (and credit) for their spending and while real median household incomes are higher today than they were in 2011, they are 4.7% lower than they were in 2008. As for credit, the consumer appears close to capacity as to how much debt they can or are willing to take on. So, it is not surprising that retail sales have been less than expected. Notwithstanding the uptick in the second quarter, retail sales are up just 1.4% year-over-year, a number that normally denotes weak or recessionary economic environments.
Considering the financial circumstances of the average worker, we don’t expect consumer spending to meaningfully improve. Adding to our concern is the fact that retail sales growth is now 40% below the average from 1993 to 2015 and consumer sentiment is now 11% above its historical average. The current dynamic may be reflecting a change in consumer behavior as baby boomers reign in spending in anticipation of their underfunded retirements. Moreover, millennials have been very slow to form households and have generally shown less appetite for buying “things,” both of which lighten their contribution to retail sales and overall consumer spending. There seems little on the short to intermediate term horizon that will change the current growth trajectory of consumer spending. So, unless something replaces the consumer as the driving force for economic growth, our conclusion is that near term economic growth will be challenged and the Fed will be very slow in raising interest rates once liftoff occurs.
For the quarter and YTD ending June 30, 2015 the MSCI All Country World Index was up 0.52% and 2.97%, respectively. For the same periods the S&P 500 was up 0.28% and 1.26%, respectively. Year-to-date equity returns were generally in line with expectations until market volatility relating to Greece and China caused late-quarter weakness across the board. Europe and Japan led the pack in Q2, driven by their respective central banks’ quantitative easing policies. In the case of Japan, a major shift in government pension fund asset allocation has funneled billions of dollars into the Japanese equity markets. Emerging market equities have been mixed so far in 2015, with Latin America and especially Brazil creating a drag on performance. Chinese stocks proved to be exceptionally volatile both up and down so far this year, but still lead all equity markets. However, the precipitous decline at the end of June was scary enough to prompt the Chinese government to halt trading on stocks going down and intervening in other ways to prevent a further decline. Chinese officials must have missed the class on free market price discovery!
US economic data has improved meaningfully from Q1 to Q2, but average GDP growth in the first half of 2015 is likely to only come in around 1.2%. This means that US GDP will have to be well above 3% in the second half of the year in order to get full-year GDP safely above 2%. It seems relatively certain that muted economic growth is the new normal, especially this far into the recovery. Furthermore, global growth will likely be challenged if China GDP growth further decelerates.
Our portfolios are invested in both domestic and foreign equity markets. Given the continued recovery in the U.S. economy and central bank quantitative easing most everywhere else, we favor being invested globally with an emphasis on the U.S. and Europe.
For the quarter and YTD ending June 30, 2015 the Barclays Global Aggregate Bond Index was down -1.2% and -3.1%, respectively. For the same periods the Barclays US Aggregate Bond Index was down -1.68% and -0.1%, respectively. Bank loans and high-yield bonds outperformed all other bond market sectors both in Q2 and YTD, while longer term Treasuries and corporate bonds were the worst performing sectors for the same periods
As noted above, the first half of 2015 provided plenty for fixed income investors to think about. Chief among investor concerns has been and continues to be when the Federal Reserve will raise its benchmark interest rate, by how much, and what the ripple effect will be on global asset prices. Also on investors’ minds is the divergent monetary policy among the world’s major central banks and the impact on currency valuations. Other factors impacting the fixed income market so far this year are the gradual improvement in the domestic economy and the resultant rebound in the high-yield market, as well as the volatility in the municipal bond market resulting from fears around Puerto Rico and other distressed areas. Finally, the issue of bond market liquidity is an increasing investor concern, both in the higher yield arena and the Treasury market.
Janet Yellen just finished testifying before Congress and continues the party line that the Fed rate hike is data dependent, but she believes that the economy will justify a rate hike before the end of the year. Some observers believe lift off will be at the September meeting and others at the December meeting. Short-term interest-rate futures contracts now indicate a January lift-off. The fact is that more important than when rates rise is the pace at which the Fed raises rates after the first hike. That pace will also be data dependent and we believe economic strength will be slow in coming as will further rate hikes.
At the beginning of the year we believed there would be a flattening of the yield curve and positioned our bond portfolio to have an overall duration shorter than the market, but held some longer term bonds. We have chosen to sell our longer dated bonds and we are in the process of doing so. For the balance of the year we expect short rates to continue moving up gradually with yields at the long end of the market dependent primarily on inflation expectations, which we expect will continue to be muted.
The most recent IMF estimate of 2015 global GDP growth is 3.3%, with advanced economies projected to grow at 2.1% and emerging market and developing economies growing at 4.2%. The problem with this forecast is that approximately 69% of global GDP is represented by the US, EU, China, Japan, UK, and Russia, only one of which (China) will likely experience GDP growth in excess of 3%. China reported 7% growth in Q1 of 2015 and just reported the exact same number for Q2 2015. Maybe these numbers are accurate, but there is a chance that the Chinese government is putting on a happy face in light of their troubled real estate market and the more recent fall of their equity market. In any event, global commodity prices remain depressed and are indicating relatively tepid global growth, which we believe will be the case in the balance of the year.
At the beginning of the year we believed the stronger dollar trend would continue in 2015 and, after retrenching for a period of time, dollar strength has continued. The Fed is now closer to raising rates while central banks of twenty countries have lowered interest rates and are poised to continue doing so. This dynamic supports the strong dollar trend and we would not be surprised to the see the EUR/USD trade at parity. As noted at the beginning of the year we expect this trend to continue for years to come as the US dollar serves as the World’s reserve and funding currency. Oil and other commodities are priced in US dollars (reserve) and the US dollar is used all over the world to facilitate loans and leveraged transactions (funding). Many countries have taken out loans in dollars instead of their own currency, which makes the debts more liquid and palatable to international investors. Because of this dynamic, when the dollar is depreciating it acts as a stimulus to world markets. However, as the dollar gains strength it acts like a broad-blanket tightening of global credit conditions.
Oil prices (WTI) began the year marginally lower than the current level of $51 per barrel and have generally stayed between $50 and $62 per barrel. In an effort to trim costs US shale producers have reduced rig counts on lower yielding wells. However, they have increased the productivity of the wells on line, resulting in production levels that remain near all-time highs. Accordingly, crude inventory levels are at 80-year highs for this time of year, providing downward pressure on prices. Further, the recent agreement surrounding Iran’s nuclear program, will likely add one million barrels a day of Iranian production sometime in the next 12-18 months. A combination of these factors is likely to keep oil prices range-bound.
We indicated earlier this year that volatility would increase and while the US equity market has remained less volatile than usual, pockets of volatility in other markets have indeed been present. The equity market in China and the sovereign debt markets are two examples of markets that have experienced outsized volatility. As noted above, there is growing concern that the bond market, especially the high yield market, has far less liquidity than investors expect. There are some mixed opinions on this matter, but we remain cautious of this issue and diligent in limiting our exposure to markets that we believe may be susceptible to liquidity concerns. To better manage portfolio volatility we have invested in a number of strategies that have very low correlation to traditional equity and fixed income markets.
The global economy is experiencing sub-par growth considering the current stage of the economic recovery and both equity and bond valuations are relatively rich. While we are confident in the diversified nature of our portfolios, we remain keenly focused on the changing financial market landscape to determine if appropriate changes are necessary. As always, we appreciate your continued partnership with us and welcome your questions, comments, and insights at any time.