Global economic growth (as measured in the combined Gross Domestic Product of all countries) has historically been driven by the stable economies of the United States, United Kingdom, Europe and Japan. Since the crisis of 2008/2009, recovery efforts in the old guard floundered. Gains in global economic output in the immediate aftermath were the result of countries such as China, India, Nigeria, Brazil, the Southeast Asian nations, and until recently, Brazil and Russia. While the large, stable economies continue their slow yet steady improvement, they have started to get back into the driver’s seat behind the global engine. However, if we have learned anything from the crisis, it is that our economic world order is a fluid system in which nothing is fixed. Remaining aware of this fluidity is what allows us to question consensus expectations and build a foundation for agreeing or disagreeing with them.
The year started out with many in the investment world believing 2015 would hold as much potential as 2014 delivered in surprises. The exuberance in global GDP forecasts for 2015 began back in January when the IMF and World Bank estimated global GDP to grow 3.6% exactly. Even after disappointing 2014 results, these organizations remain stubbornly hopeful. The first downward revisions have already appeared, and it is just February.
2014 was a year of mixed results for the economic world. America posted a negative turn in economic expansion growing by only a meager 2.1% (slower than the year before- “unusual weather” was the whipping boy). This was offset by a better environment on the European continent with the potential for debt defaults in Greece, Spain and Portugal greatly reduced. The U.K. economy picked up speed and even Japan provided a hint of growth by the end of the year.
The start of 2015 has been full of surprises: lower oil prices, Greek elections, Ukrainian tensions, good economic data and increases in corporate earnings have all roiled the stock and bond markets.
US Domestic Economy- GDP, Interest Rates, Money Supply
At Charter Trust, we remain skeptical of the consensus expectation for the global economy; 3.6% is too optimistic. Our forecast for 2015 is for global growth of developed markets around 2.6% to 2.8%, well below the IMF’s prediction. We feel that Japan still has a long way to go and Europe needs at least 12 months of recovery before solid growth materializes, especially with the drama surrounding Greece’s extended bailout. The U.S. will continue to enjoy stable and lower energy costs. Some of the emerging market economies will flourish with the lower oil prices while others suffer. Differentiation is key. However, we do not see a breakout of the slow and consistent growth recovery of the past several years. Our forecast is for continued growth on a steady path.
U.S. economic growth has continued on a slow, steady upward path as shown by Gross Domestic Product in the chart above. A generally accepted standard is that economic expansion needs to advance at approximately 3.0% for unemployment to go down. Once the labor supply steadies, wages will increase (good for everybody). The current unemployment rate is 5.7% which is a great improvement from 10.0% just a few years ago, but not close enough to the government’s target of 5.0%., or full employment at 4.0%. With GDP at a current expansion rate of 2.6% the country is improving, but not at a rate that would advance job growth quickly.
Recently, there has been increased concern over the effects deflation would have on GDP growth. Now most everyone knows what inflation means.
Inflation – A persistent increase in the level of consumer prices or a persistent decline in purchasing power.
But, what is deflation?
Deflation – a persistent decrease in the level of consumer prices.
The Federal Reserve (Fed) has been forecasting, re-forecasting and un-forecasting interest rate increases in the inter-day bank rate (the interest rate at which all other products are based) for so many years such that everyone keeps expecting a rate increase “soon”. How soon? The increase was expected in mid-2012, by last January, the industry was expecting mid-2014 and most recently, the expectation is early 2015 or possibly even mid-2015. The anticipation has marked effects on both the bond market (keeping yields low) and the stock market over the short (<1 year), and medium term (1 to 5 years).
Why hasn’t the Fed increased rates yet? They worry that if economic growth is not strong enough, raising interest rates could potentially slow economic growth and create a deflationary environment. Usually we worry about inflation, but as the chart below shows, prices have been increasing at a very low rate. A spiral in deflation can quickly lead to an economic slowdown, as people put off buying in anticipation of lower prices later on.
The current rate of inflation, -0.3%, is well below both the average 3.3% and median 2.8% since 1914. The Fed is not getting no support from inflation to increase interest rates. Additionally, the Producer Price Index is not sending support signals for a rate increase. Producer prices have declined most recently by -0.8%. Usually, consumer inflation does not appear until after producer prices show positive signs.
One ingredient necessary for economic growth is an increasing money supply (the total amount of monetary assets available in an economy). There are many variations of money supply. The two most common ones are M1 (total amount of cash and deposits outside private banking) and M2 (M1 plus savings accounts). Arguments are plentiful amongst academics on which measure is the best. We use M1 as it covers a broad section of the economy and has a consistent history.
Money supply has grown throughout time, but at dramatically different rates. The growth rate of the money supply was nearly flat in the early 90’s but followed by a rapid growth period that lasted well into 2003. The Great Recession was prefaced by a rapid rise in money supply followed by a deep contraction immediately afterwards.
Since 2008 the Fed has attempted to stimulate the economy through several rounds of quantitative easing nicknamed QE1, QE2 and QE3. Money supply has increased throughout all three programs, but has not had the desired impact of improving economic growth (GDP). Neither has it created an inflationary environment.
The question facing the Fed now is can they increase interest rates and at the same time avoid slowing the money supply or the economy? While the answer to this question may remain a mystery, we are nearly certain interest rates will not move upward before mid-2015 and have an equal probability of remaining low (rates below 3%) for several more years. While this benefits the consumer through low borrowing rates and stable consumer prices, this will present a continuing low yield environment for bonds and we have lowered allocations accordingly.
World Market Review
Market growth in in the U.S. has continued along a relatively smooth path. Emerging markets continue to hold their own after a fast start in 2009. It will be hard to restrain markets such as China, India and Nigeria over the long term. Why? By 2050 Nigeria will be as large in population as the United States. By that time, the Chinese middle class alone will have the economic buying power of the entire U.S. today.
Global growth is still evident throughout the world but slower than in the US. For some reason, slow and steady growth is a disappointment to tactical investors and central bankers. Longer term strategic investors are benefiting from excellent growth that will pay off over the next decade.
U.S. Dow Index with Emerging Market Index
This chart shows the Dow Index (green/red) and the Emerging Markets Index (blue). Directly after the decline of 2008, great expectations influenced emerging markets which produced a rapid increase in stock prices (well above U.S. Largecap stock values). The recovery of developed markets was not as robust as anticipated. The result for emerging markets was an adjustment downward to more realistic values. Since 2012, emerging markets have been in a holding pattern, seemingly looking for improvements in U.S. economic growth. The U.S. economy is the engine for smaller markets and can effectively produce a sizable increase in these markets. As long as the U.S. advances slowly, it may take some time for emerging markets to show significant growth. This makes it a good time to buy into selective emerging markets for their longer term potential as the US, Europe and Japan continue to gain strength.
European Union markets (Euro Zone and U.K.) have shown a similar pattern to the United States. In the chart below, the comparison is between the U.S. Largecap market,
U.S. Dow Index with U.K. & European Index
U.K. (red) and European (blue) large cap stocks. In this case, expectations for all three markets were nearly identical, until late 2011 when Greece, Spain, Portugal and Ireland all posed significant risks to the stability of the Eurozone.
In terms of market valuations, the U.S. market remains within Fair Value (FV) at a current level of 110% FV (18,140). The most recent drop in the market was caused by an adjustment of expectations when both the World Bank and IMF revised their growth forecasts downward. (We discussed this earlier in the beginning of this report.) The market adjusted well within normal market valuations and just recently returned to a 110% valuation.
The United States, Europe and the United Kingdom are currently above our Charter market forecasts, especially Europe and the U.K. We do not expect either Europe or the U.K. to exceed returns for the U.S. in 2015 due to Greek sovereign debt pressures and uncertainty over European Central Bank QE efforts. This is the ECB’s first time at QE so cautionary eyes are watching. If the U.S. continues to grow slowly, both markets should add nice value over the next 12 months.
Corporate earnings performed well recently. This has created an environment where stocks are more reasonably priced than just two months ago and offer above average probability, 75%, of continuing on a long term path of opportunity (higher earnings create higher fair values.)
US Domestic Stock Market- Opportunities in Energy
Looking at individual sectors within the domestic market, energy presents the greatest long term opportunity. Each of the 10 domestic sectors is shown in the table below. Energy, in dark green, is highly under-valued. The undervaluation (opportunity) warrants an additional weighting of 2.79 percentage points over the current market weight of 8.4% (yellow cell). Energy should be weighted at 11.2% (blue cell).
The energy sector is an opportunity when the sector is undervalued because supply is plentiful but long term demand is increasing. Currently, there is a continued demand for fossil fuels, oil, natural gas and coal in fast growing and stable economies. Even at an accelerated rate, alternative energy sources will need an additional 100 years to become an equally reliable resource. While the U.S. and other parts of the world expand exploration and extraction using tight oil processes, the opportunity for investment now may be the best since 1933 when Standard Oil received permission to construct an oil rig in Saudi Arabia.
Many of the oil sector companies have already adjusted capital expenditures to meet the new landscape of increasing supply coming from new extraction processes. After a few months of adjustment, supply and demand are expected to equalize and normal pricing can resume.
Just as an undervaluation condition exists in energy, an overvaluation condition exists in healthcare. Expectations are high in healthcare for many reasons: aging of the population, Obamacare, insurance market changes, biotechnology and global advances in the distribution of healthcare related services. Unfortunately, expectations are far ahead of reality. Currently, stock prices are 1.67 percentage points above the market weighting of 14.2%. This is a significant part of the domestic stock market. Only two other sectors are as important as healthcare: finance and technology. Healthcare stocks have an important influence upon the overall market performance. We expect healthcare to underperform the overall market until either earnings improve or expectations come down. Charts for both the energy sector and healthcare sector are shown below.
U.S. Energy Sector (XLE)
U.S. Healthcare Sector (XLV)
Where Are the Risks?
Every forecast can be based on logic, statistical reasoning and experience and still get sidelined by unexpected events that range from geopolitical, natural disasters and behavioral triggers. This graphic explores the impact some of the most significant factors might have on stock marketsover the next three years.
We have selected the eight factors below that could have unexpected yet significant effects on market performances. In general, the impact of these influences has largely been worked into market prices but we can expect these factors to have the following sway:
- U.S. Energy Exploration and Independence – has been an influencing factor since 1940. In the ‘40s America was the world’s oil supplier and global confrontations were based on control of this valuable resource. Most recently, the U.S. has gone from a net importer to an independent producer with high potential for global exports. This has come about as a direct result of advances in exploration technology. If America continues along the path towards becoming a net energy exporter, the impact on the economy and market will be positive over the next 3 years. It will also have greater influence each year if the new found supply can continues to grow at a flat or increasing rate. The impact would be lower energy prices around the world and economic value added due to work in exploration, refinement and distribution.
- Foreign Direct Investment into the U.S. – has increased over the past 4 years due to relaxation of the US$ in the world’s currency markets and expanded consumer purchasing strength. The country has several important key components that attracts foreign manufacturing: stable energy sourcing, predictable and stable legal system, stable financial structure and reliable resources. These have been able to offset the negative tax program. The corporate tax structure is expected to improve within 3 years but not within 12 months. We would see greater foreign direct investment 2 or 3 years from now if tax reform is possible.
- U.S. Enterprise Earnings – have been stronger than most expected, especially relative to global corporate earnings. This is expected to continue throughout 2015. Earnings will be positive in 2016 and 2017 but not at the same rate of improvement we saw in 2014 and 2015 and not at such a high relative position globally. Positive earnings growth will favorably influence American markets but it will not be as influential.
- Economic Growth – follows the same path as earnings: strong influence in 2015 with a slight reduction in 2016. In 2017 it will be more difficult for the U.S. to see economic growth positively influence stock markets because global growth will accelerate in emerging markets. Assets are expected to move from the slow to moderate growth market in the U.S. to faster growing emerging markets such as India, Brazil, China and African nations such as Nigeria.
- European Debt – is a problem that potentially can shift from a slightly negative concern to a disastrous outcome. Fortunately, we believe conditions are improving as evidenced by the agreement reached with Greece in regards to its bailout extension. All sides are willing to “scare” the markets but, in the end, remaining within the Euro Zone benefits all. With the new agreement the Euro was strengthened in solidarity. If the Euro can get past this period of uncertainty it can take a place of increasing global importance.
- Geopolitical Confrontation – has changed significantly over the years and remains a disruptive factor. Earlier concerns resided inside existing geographic boundaries and recognized governments such as North Korea, Iran, and Russia. These remain threats but have taken a back seat to non-geographic bound nationalistic efforts such as ISIL. If ISIL is allowed to surround the Arab countries of Saudi Arabia, Kuwait, UAE, Qatar, and advance on Turkey, the threat becomes significant. Efforts taken by the countries impacted by such a threat are just beginning and should be able to neutralize the negative impact of the organization. ISIL was effective because of an earlier underestimation of their capabilities and influence. This is not occurring today, especially in the impacted Arab countries.
- Cyber Threat/ Fire Sale – this is by far the most significant threat of the group. If a full fire sale is initiated, the markets would deteriorate quickly. Even though the thought of financial companies and utilities losing function, even momentarily, is frightening, the threat is more behavioral than physical. Is a fire sale possible, or just a myth? Many in government have classified it a myth, however they also thought massive credit data theft was a myth as well. An assessment made by cyber professionals is that enterprises in the developed world are only spending approximately 10% in time and software of what is required to make a serious effort in cyber and infrastructure security. The events are getting more serious. The attacks have changed as well. Now totally unsuspecting benign networks are being used to infiltrate important networks. This was evident when the HVAC service access was used to work through a financial network that eventually resulted in data on over 200,000 credit cards being taken. Until enterprises take a cyber-threat seriously and not just follow “best practices” will the threat be reduced.
- U.S. Debt – debt was getting dangerously close to weighing down the country’s ability to expand. Service of debt potentially could sap the slight economic growth or reduce GDP by 1%. Fortunately, national debt is shrinking. If the trend continues and spending does not accelerate, its impact on the markets will decrease over the next 3 years.