September 2015 Monthly Commentary

In a world where homes and art work sell for over $100 million it is no wonder that our eyes glaze over when we hear people speak of monetary references in the billions of dollars, let alone tens or hundreds of billions of dollars.  So, when one sees an eight followed by 12 zeros they don’t think $8 trillion, they likely think it’s just another big number.  However, $8 trillion is lot of money, no matter how jaded, naïve, or tuned-out to reality one might be. In fact, $8 trillion is the amount of economic stimulus sovereign central banks have injected into the global economy by way of quantitative easing (bond buying, etc.) since the onset of the Great Recession. In addition, the Federal Reserve led many other central banks to a zero interest rate policy in order to further ease the financial burden of banking institutions, businesses, and individuals dealing with a collapsing economy. What began as an emergency measure to prevent a repeat of the Great Depression and to then revive economic growth has morphed into central bank standard operating procedure that has proven to be little help in fueling economic growth or lifting the deflationary pressures of global excess capacity.

The Fed has maintained its zero interest rate policy for nearly seven years hoping to encourage borrowing, spending, and investing and thereby boosting economic growth.  In fact, the borrowing, investing and spending that has ensued has been mainly by investors and market traders who have borrowed cheaply and invested in carry trades (higher yielding fixed income) and/or rode the wave of increasing equity markets driven up by yield-starved investors taking on more risk than advisable under normal conditions. The result has been an asset inflation accruing to the benefit of financial market participants, but not Main Street.

Notwithstanding the feeble results of 81 months of zero bound interest rates, last week Janet Yellen and her Fed partners chose not to raise rates even 25 basis points. Long past the point of emergency crisis management, one would expect the Fed to cease a policy of artificial interest rate pricing, which would force legislators to address the fiscal and structural changes necessary to address our financial challenges. The well-respected head of the Reserve Bank of India, Raghuram Rajan, recently commented that “a policy of monetary easing by central banks is really only a lubricant to growth, it is not the underlying driver of economic growth.”  There is overwhelming academic and practical evidence that a zero bound interest rate policy is but one response to economic weakness and used alone is an insufficient measure.

To wit, Japan has employed a near zero bound interest rate policy for nearly 25 years and even more recently entered the most aggressive asset-buying policy in modern times. To say that Japan’s monetary policy is pushing the proverbial string is demonstrated by four recessions in the past seven years and half way into its fifth with negative GDP in Q2 2015. The demographic and structural circumstance of the US is better than Japan so we have avoided recession, but we have not avoided the malaise of slow growth. Following in the monetary-easing footsteps of the Bank of Japan and the Federal Reserve is the European Central Bank that is now six months into a bond-buying program that has driven interest rates into negative territory.  Alas, similar results appear to be the case in the EU as meaningful growth remains absent and deflationary pressures have inflation hovering near zero.

The challenge we are facing is that consumers have reached a level of peak debt, which means there is no more room on their balance sheets for additional borrowing – no matter how low interest rates are set. Similarly, corporate America has no appetite to borrow and invest when global growth is low and uncertain. Corporate America has been willing to borrow cheaply and buy back stock, which has increased earnings per share and helped to push the equity markets higher.  However, this is a financial parlor trick that doesn’t change the fact that slowing global growth has resulted in declining top line revenue or that profit margins are not likely to increase from current historical highs. While low interest rates have partially “justified” higher earnings multiples, corporate earnings must continue to grow in order for multiples and equity markets to hold current levels.

An additional challenge is that a confluence of global economic factors weigh heavy and will likely begin to impact US shares, beyond the most recent market pullback. The extent of China’s slowing economic growth is unknown, but we do know that their unrestrained and unnecessary infrastructure build left the world with huge excess capacity and collapsing commodity prices. This dynamic has created deflationary pressures that have rendered ineffective the inflation-inducing efforts of global central banks and will continue to serve as a headwind to global economic growth. A combination of lower commodity prices and the strong US dollar have most South American economies in or about to go into recession, lower oil prices have Russia and Canada in recession, and the EU struggles to mount even a modicum of economic growth. Japan had a negative GDP print last quarter and the rest of Asia and the emerging markets are feeling the effects of slower economic growth and the stronger US dollar.

While the US economy continues to show improvement, especially employment and housing metrics, we believe that it is growing increasingly difficult for the US to remain decoupled from the global economy. Stock markets are a leading economic indicator and the recent decline in the US indices could well be telegraphing deepening economic concerns rather than merely an overdue technical correction. Moreover, credit spreads have widened indicating the bond market’s concern about the economy.

We continue to challenge the conventional thinking that has so many investors “buying the dip” with the belief that the economy is strong and equity prices will move ever upward. In fact, we believe that the current environment calls for elevated levels of circumspection by investors. Accordingly, we continue to look for new ways to further diversify our portfolio risk to protect member capital. As always, we appreciate your continued partnership with us and welcome your questions, comments, and insights at any time.