As we mentioned in our beginning of the year Global Outlook, the delay in resolution to the Fiscal Cliff had an adverse effect on the economy in the fourth quarter—GDP came in at a near stall speed of 0.4%; and, the automatic sequester cuts didn’t help the recovery from that slow growth—Q1 2013 GDP came in at 1.8%. We believe the economy is showing gradual, incremental signs of improvement but we are not nearly as optimistic as the Federal Reserve appears to be. Economic growth for the full year will struggle to get much above 2%; and, the unemployment rate will likely remain at the 7-7.5% level. The story really hasn’t changed over the past four years: fiscal policy is non-existent due to Washington’s political gridlock and monetary policy can only spur so much growth.
Some Federal Reserve Governors have recently expressed concern about the trajectory and absolute level of inflation. The Personal Consumption Expenditures Index, the Fed’s preferred measure of inflation, has been declining consistently over the past year and presently stands just above the 1% level (below 1% is considered to be dangerously deflationary)—the slowest rise in prices over the past 50 years. Chairman Bernanke and the Federal Open Market Committee have outlined a data-dependent timeline for withdrawing quantitative easing. Should the Fed’s optimistic projections pan out, the Fed would begin cutting back on its bond purchases toward the end of this year and stop them altogether by the middle of next year. Unfortunately, the Fed has consistently been overly optimistic in its economic projections over the past four years. We don’t believe quantitative easing will end until the Fed is certain deflationary pressures are off the table—which would equate to a Personal Consumption Expenditures Index closer to 2% than the current 1%.
Short-term interest rates will remain low for some time. Longer-term US Treasury yields, which have risen significantly over the past two months thanks to the Fed’s discussion about removing quantitative easing, are comprised of two component parts: a real interest rate plus an inflation expectation. The 1% rise in the 10-year US Treasury yield since the end of April was comprised of a 1.25% rise in real yields and a 0.25% decline in inflation expectations. We would expect the real interest rate component to rise another 0.5% when the Fed does finally cease its quantitative easing—we don’t expect that to happen until inflation expectations increase. As noted above, we have more deflationary than inflationary pressures at present. As a result, we expect longer-term interest rates to stabilize and likely decline a bit from these levels over the balance of this year. Longer term we expect the Fed will eventually succeed in engineering higher inflation rates and therefore higher long-term interest rates as both real interest rates and inflation expectations rise.
Domestic Equity Markets
Stock prices follow corporate earnings and we believe the corporate earnings environment remains positive even as the overall economic environment remains sluggish. We also believe stocks will continue to benefit from an overall reallocation from bonds to stocks by investors. Individual investors have been woefully underweighted in stocks since the financial crisis, and institutional pension plans will have a difficult time achieving 8% actuarial rates of return with any investments in investment grade bonds yielding 2.5%. The stock market still offers comparable yields, far more upside, and only slightly more downside than the investment grade taxable bond market. We remain bullish on the stock market over the balance of this year.
Domestic Bond Market
The domestic bond market experienced a major re-pricing over the past two months. Investment grade bond indices were down 4% as bond yields rose nearly 1%–the biggest two month decline in bond indices and rise in rates since the height of the financial crisis in late 2008. We think investors misinterpreted and overreacted to the Fed’s message, and we would expect bond yields to stabilize and likely decline modestly over the balance of this year. Longer term we believe bonds are a poor investment as they still offer historically low yields, little upside and lots of downside risk as investors experienced these past two months. Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics.
Europe is in a recession and many of the emerging market economies, particularly China, have definitely slowed down. Central banks across the globe, with the exception of Japan, are looking for ways, like our own Federal Reserve Bank, to ease their respective economies off of the monetary stimulus drip they’ve been on for the past several years. The monetary stimulus policies recently adopted in Japan are having an impact—the Japanese economy finally appears to be emerging from two decades of deflation.
Slowing growth in the emerging markets coupled with most major central banks contemplating exit strategies for monetary stimulus should keep inflation in check. We still believe that deflation may still be a greater risk than inflation to the overall global economy.
As with the domestic market, we expect global short-term interest rates to remain low. Longer-term interest rates in most major markets are still near historic low levels. Any improvement in economic activity will drive those rates higher—we don’t expect that to happen over the balance of this year.
The dollar has had quite a run ever since the Fed started talking about curbing its bond buying activities. Just as we expect interest rates to stabilize at these levels, we would expect the dollar to do the same versus most major currencies with the exception of the Japanese yen—we expect the yen to continue weakening.
The slowing of emerging market economies, particularly China, and the strength in the US dollar, has had a direct negative impact on commodity prices. We don’t see that changing over the balance of this year, but longer-term we believe the emerging and frontier markets will resume their growth trajectories and natural resources will follow.
Global Equity Markets
While emerging market economies continue to show signs of slowing, we believe some of those markets’ stock valuations are becoming attractive. At present we still have a bias toward domestic versus international stocks; frontier markets over emerging markets, and small cap stocks over large cap stocks in both domestic and developed international markets.
Global Bond Markets
Most of the weaker countries in the Eurozone (Greece, Italy, Spain) have seen their bond yields come down dramatically in recent months. While we haven’t read or heard much about the European sovereign debt crisis lately, it doesn’t mean it’s been resolved. We believe the risk is still there but the potential reward has been greatly reduced. We would favor higher rated developed European countries at these levels. We remain underweight emerging market debt as we don’t believe investors are being compensated for the reduced liquidity and lower credit quality in those markets.