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BBVA Compass

Quarterly Market Update

Q&A

In this edition of BBVA Compass Market Outlook, Managing Director of Portfolio Management, Gwynne Shackelford and Investment Strategist, Anne-Joëlle Viguier-Galley postulate that China may pose a threat to the current U.S. economic expansion which has proven to be more anemic for longer than would be expected after the recession ended in 2009. Ms. Shackelford and Ms. Viguier-Galley examine the implications for the U.S. and the rest of the world of China’s attempts to shift from being the export machine of the world to becoming more domestically consumer oriented which has slowed the pace of growth in the world’s second-largest economy.

1. In last quarter’s issue of BBVA Compass Market Outlook, you indicated that the Federal Reserve’s measured exit from quantitative easing would create a drag on the U.S. economy in 2014. Has your outlook changed?

The Fed announced plans in December to begin incrementally drawing to a close the $85 billion monthly bond purchases which began in September 2012. Most recently, Fed Chairwoman Janet Yellen announced that the Fed will trim bond purchases to $55 billion in April from $65 billion in February and March and $75 billion in January. Due to the timing of the exit, which we anticipate will be completed in the fall, assuming U.S. economic growth continues on the current path, we continue to believe that this reduction in the bond purchase program will put a slight damper on growth because it reduces liquidity and thus generates more volatility in the markets, which impacts both consumer and business confidence. We do, however, view this as a positive in that growth, albeit slow, and job creation are finally sufficient to allow the Fed to end large scale asset purchases that have increased the Fed balance sheet to $4.3 billion from $800 million in the past five years.

Recently the outlook for tapering has been complicated by exceptionally bad winter weather along with global growth concerns, specifically driven by China. Jawboning at the political level involves the potentially negative impact of the Fed’s tapering upon the rest of the world. This in turn increases market volatility and leads to confusion about whether the Fed will change its mind.

Certainly while a focus on the U.S. by the Fed is important, it cannot afford to be agnostic to what is happening in the rest of the world. But in our opinion, while the Fed is keeping an eye on global events, it is primarily looking through the lenses of how these affect the U.S. It is unlikely (unless there is a major crisis event) that plans will be set aside solely because of economic conditions in China or other countries.

2. In your opinion, where does the Fed’s current tapering initiative fall in terms of timing - too soon or not soon enough?

Shall we say it is too soon to tell? It is a toggle - the Fed can accelerate tapering if economic growth picks up, or put on the brakes should growth slow. There are currently no inflationary pressures of the sort that the Fed monitors to say tapering has come too late. Instead economic growth seems sufficient to withstand tapering. Another key consideration is bond yields and while yields have risen, they have not skyrocketed.

The scope of global monetary stimulus has been unprecedented and the unwinding has created considerable noise and market volatility. Central banks worldwide including Japan, the United Kingdom, China, Europe and the U.S. have injected trillions of dollars or similar stimulants into their monetary systems since 2008 in order to relaunch economic growth. While the unwinding of such monumental stimulus is without doubt unchartered territory, getting out sooner is preferable to later. Even though tapering will to some extent keep a lid on markets and economies, in the long run it will be healthier for U.S. growth.

3. Just how well is the U.S. economy doing?

The U.S. economy continues to improve slowly and below what would be expected at this stage of the recovery. To some extent financial markets have accepted this trajectory for now.

4. What are some of the risks to U.S. growth?

In our opinion, one risk scenario is China. China is engineering a shift from being the export machine of the world to becoming more consumer-oriented, and in the process transitioning from an emerging market to a more developed economy. To achieve this advance, the Chinese government must eliminate vast disparities between the recently emerged über-wealthy class and the hundreds of millions of “normal” Chinese by better spreading the income to the middle class. Such a social and structural shift will take time – five, ten years or more.

China is in a very different economic developmental stage than the U.S. Indeed the slowing of their GDP growth, rather than being a concern, is an appropriate outcome of China moving from a third world to a more developed country. An $8 -$9 trillion economy cannot continue to grow at a rate of 10-12% for an unlimited time. While the slowdown is both logical and normal, what will eventually be good for the country is not necessarily good for equity markets in the short term, and as a result financial markets have experienced a great deal of volatility. Should the economy derail because the country is so large and the transition is so challenging, then concerns about a threat to global growth stemming from those changes will persist.

Also complicating the secular change is the looser monetary policy which China enacted between 2008 and 2012. Like the U.S., China must maneuver their restrained monetary stimulus in such a way that a soft landing is achieved. China still retains the ability to use fiscal policy to mitigate the impact, but that is a very thin line because there are almost 1.4 billion Chinese citizens who want more, particularly the younger generation. For example, whereas in the U.S. we stockpile oil, China stockpiles rice. What would happen if the government could not feed the population? The potential for political unrest and social upheaval is increased should a billion people become dissatisfied with the rate of development and change within the country.

5. Are there other implications of a slowdown in China’s growth rate for the U.S. and the world?

While U.S. inflation has hovered consistently below the 2% rate targeted by the Fed, the changes in China’s economy described above, among other factors, could drive U.S. inflation in the future. For years one of the reasons the U.S. had such low inflation was because we were able to import deflation from China through the import of very cheap goods. As China becomes more of a consuming nation, that positive benefit should tend to disappear. Average salaries have been increasing in China, as the transition to elevating the middle class requires additional income. While this is good for the Chinese, it means that many companies that were manufacturing there very cheaply are now reconsidering. Should this manufacturing be moved back to the U.S., it would be good for our economy. We are already seeing some anecdotal evidence of this happening.

Conditions in China could potentially have a greater impact on Europe than the U.S. for several reasons. Europe is earlier in the recovery cycle than the U.S. and does not have the margin of error, or cushion, in terms of GDP growth that the U.S. has. Also, the European Union (EU) is one of China’s main trading partners. China’s GDP should still be around 7.2% to 7.5% this year, with the second half better than the first half. Within the EU, Germany has the highest trading links to China and this, together with the recent geopolitical events in Russia could pressure the German economy.

6. What are the most important considerations for investors?

We would caution investors not to overreact to events in China, but instead to focus on their investment time horizon. When building a portfolio, macro events can easily become a distraction. While a dramatic slowdown in China’s economic growth would not be an insignificant event, ultimately an investor’s time horizon will dictate how much they have invested in equities. And hopefully, through professional money management, exposure to China’s equity market or other volatile markets will only be in an amount appropriate to the client’s tolerance for risk.

Ultimately, the successful anticipation of macro issues and a seer’s ability to time the markets are not determinative, but it is rather the discipline to stay in the markets, that mitigates risk. Certainly no one forecast last year’s 30% returns in the U.S. stock market. The only way to reap the reward was to have been invested. The route to investment success is to have an understanding of one’s time horizon, a defined investment objective and risk tolerance and a disciplined investment strategy.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).