Quarterly Market Update
Increasingly apparent is the divergence of the pace of U.S. economic growth from the rest of the world. In this edition of BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley examine global monetary policies and explore reasons behind some of the disappointing results.
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1. Please provide an overview of global monetary stimulus programs and the relative success of each.
Monetary policies across advanced economies are diverging as countries entered, and are departing, the Great Recession on a different timetable, impacting the monetary policies of each country. Increasingly apparent is the divergence of the pace of U.S. economic growth from the rest of the world as the U.S. continues a moderate expansion while the rest of the world appears to be slowing. Although the economic recoveries of other advanced countries are running behind that of the U.S., it was widely believed that the trajectory of each recovery would be similar, resulting in sustained economic growth. Investors anticipated that quantitative easing programs, styled after those executed by the Fed, which many credit with the advance in U.S. stock markets for the past several years, would do the same for foreign stocks. The attractiveness of European and Japanese equities increased roughly in tandem with central banker announcements of additional monetary stimulus. According to Lipper’s preliminary fund flow numbers, despite increasing geopolitical concerns, fund investors favored nondomestic equity funds over domestic ones, investing $14.8 billion versus withdrawing $12.9 billion in third quarter, respectively.
Despite unprecedented levels of stimulus pumped into global economies, results have been disappointing. In Japan, the economy contracted at a 7.1% annualized rate after rising 6.0% in first quarter. Japan, who pioneered Asia’s low-cost export model after World War II, has seen export growth fall, despite sharp decreases in the yen, in the face of slowing global demand following the recession and the weakening competitiveness of Japanese manufacturers.
Continental Europe is the laggard among advanced economies, trailing that of Japan, the UK and the U.S. Sanctions by the U.S. and the European Union on Russia have created an additional headwind for Eurozone growth. In the second quarter, GDP growth was flat and inflation fell to its lowest level in five years. In Germany, the growth engine of the Eurozone, industrial production and exports have fallen, and the economy shrank in the second quarter for the first time in over a year. The real concern now is a potential deflationary period which can be the most difficult economic cycle to break.
Investors are concerned that the weakness in Europe, the continued malaise in Japan, and the slowdown of China’s economy will potentially derail the still modest recovery in the U.S. The concern became increasingly apparent as the quarter progressed. The U.S. continues to “taper” its monetary easing as the economy improves, while the UK is widely expected to be the first developed nation to raise rates. Japan and the Eurozone remain in an extremely accommodative stance, however they have not provided the level of stimulus that the U.S. provided, in part due to structural differences and differences in mandates from country to country.
2. Why has the Eurozone not simply followed the Fed’s example in terms of monetary stimulus?
The Eurozone is still playing catchup as other economies took more aggressive action in the aftermath of the global financial crisis of 2008. Part of the delay in implementing policies that would shore up the economy and prevent deflation is attributable to the entity’s organization. The Eurozone is a currency union – a group of countries, each facing a unique set of challenges, loosely united under a single currency – rather than a fiscal or economic one. In the six years since the crisis began, the Eurozone has been unable to reach a consensus among the members of how to address the problem. The ECB is running out of arrows in the quiver and is beginning to resort, much as the Fed did a few years back, to lecturing politicians about stepping into the void to help on the fiscal and policy side. Such lectures tend to rattle financial markets even further because it underscores that there are limits on the ability of central banks to affect economic growth.
3. What steps are the advanced economies taking to turn things around?
Many advanced economies are in need of structural reforms which by their definition take decades to realize. In the 1Q14 issue of the BBVA Compass Market Outlook, we discussed the structural reforms that China is seeking to implement to shift from being the export-machine of the world to a more domestically consumer-oriented economy. Germany, the Eurozone’s most industrialized nation, has been making structural changes for over 20 years – since uniting East and West Germany. But exports have suffered this year because of issues with Russia and economic weakness in China. German Finance Minister Wolfgang Schaeuble, who views U.S. styled quantitative easing as an ineffective solution that introduces “moral hazard” as it relaxes pressure on governments to make needed structural reforms, has called for budgetary discipline.
But ECB President Mario Draghi has pledged to continue loosening monetary policy if necessary. In June, the ECB became the largest central bank to set a negative rate on bank deposits, a measure designed to encourage bank lending. In September, the ECB lowered the rate on bank deposits even further from -0.1% to -0.2%, and cut its main lending rate to 0.05%.
In Japan, Prime Minister Shinzo Abe, who took office in 2012, is following a three- pronged approach, dubbed “Abenomics,” which combines large monetary stimulus, fiscal flexibility, and supply-side reforms focusing on deregulation, corporate tax rate cuts and other impediments to growth to spark inflation and lift Japan out of its decades-long doldrums. The central bank’s target interest rate is currently at 0.10% where it has languished since 2010. While Abenomics has seen some initial success, growth in Japan has continued to slow. Again, structural reforms, like the ones to promote changes in industry, increasing the number of small and medium enterprises, or expanding the participation of women in labor force, will take time, and the question is still open as to how much of these reforms can begin to be achieved while Abe still has support.
4. When do you anticipate that global economies will begin to raise interest rates?
In a September speech, the governor of the Bank of England, Mark Carney, announced that with the UK’s economic recovery on track, that it was time to begin normalizing interest rates, gradually increasing the central bank’s benchmark interest rate from its current level of 0.5% in the first quarter of 2015. Unemployment did not reach the levels experienced in the U.S., and while wage growth has been similarly anemic, more UK residents are currently at work than before the financial crisis began. The UK economy grew at an annualized rate of more than 3% in the first half of the year.
In the U.S., the Fed is expected to raise the federal funds rate from its near zero level where it has been for six years later in 2015. The Fed should exit its asset- purchasing program on October 29, but will hold interest rates low for a time after that, basing its decision to raise rates on a combination of data-dependent measures, a target inflation level at or above 2.0%, and the unemployment rate below 5.75%.
There is considerable pressure from other countries not to increase rates too quickly because they need a strong U.S. economy. Undoubtedly, the U.S. and the remainder of the world will close monitor the impact of higher rates once/if the UK follows through with its plans.
5. Please discuss the outlook for the U.S. dollar?
After weakening for several years as concerns mounted regarding the $17 trillion federal deficit, the U.S. Dollar Index which tracks the dollar’s strength relative to the euro, the yen, and other currencies gained in third quarter. Currencies typically advance or decline according to two critical factors – the strength of the economy and the direction of its interest rates. Although U.S. economic growth has been modest, it is significant relative to much of the remainder of the advanced world, and the Fed is contemplating raising rates in 2015.
Perhaps artificially inflating the dollar are two other factors in the U.S. Treasury market – flight to safety and yield grab. While the dollar-denominated U.S. Treasury market is typically a parking place for investors roiled by geographic and economic uncertainties, foreign investors are also buying U.S. Treasuries because as low as rates are, they are much higher than those of other countries. Recently the yield on shorter-dated German debt turned negative, and the 10-year German Bund was yielding 0.95% compared to 2.49% on the 10-year Treasury at quarter-end.
According to an S&P Dow Jones Indices report, companies in the S&P 500 Index generated 46% of their sales outside the U.S. in 2013 . There are some concerns that weakening foreign markets and a strengthening dollar could impede exports, creating a challenging environment for U.S. corporate earnings. But the dollar’s trajectory is ultimately self-correcting. If the dollar strengthens, it is because the U.S. economy is doing better relative to the rest of the world. Should our economy begin to weaken and that is reflected in a weaker dollar, then the weakness improves our exporting capabilities, making our goods cheaper abroad and putting some level of support under corporate America. Also, a strong dollar means all imported goods are cheaper, a plus for consumers (and one reason why oil prices have been dropping).
6. What is your outlook for the U.S. economy and financial markets?
The U.S. economy is at a critical inflection point. The question is whether or not the economy is on the cusp of a self-sustaining growth trajectory. Devoid of monetary stimulus for the first time in six years, can the U.S. economy not only stand on its own two feet, but grow GDP at a healthy 3 to 4%? We will find out in the next six months, but in our opinion, self-sustaining growth is possible.
With only one quarter remaining in the year, technical reversals are probable, particularly until after the elections. We are potentially witnessing a correction phase now, but it could turn around fairly quickly. It does not follow that the economy is about to collapse or even stagnate because of this. Stock valuations were stretched and this would indicate that we were due for a correction, but not a big bear market. It remains to be seen how weakness in Europe will impact third and fourth quarter earnings. Generally speaking it is abrupt moves in the dollar that lead to companies missing their earnings estimates as a strong dollar means that accounting profits of subsidiaries abroad of large U.S. companies are lower. When the dollar rises at a more predictable pace, the strength is more readily reflected in estimates.
7. What are the implications for investors?
The speculators are very busy, so it is a good time for investors to remember not to let emotions impede long-term goals with rash decisions. No one can time the market short-term so it is important that investors not buy into the hype, believing that someone can actually tell them when, or how, to time the market. It is impossible to predict when a trend changes, they stay in place longer than might be anticipated. For this reason, investors must keep to long-term targets and disciplined rebalancing as prices look cheap or expensive.
We remain constructive on equities and anticipate there will be opportunities going forward to add to portfolios as excellent companies for the long term become available at cheaper prices. It is important to remember that every correction presents opportunities for the future growth of a portfolio.
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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).