Four states and many plane rides were interwoven with lots of phone calls, emails, market notices, and media alerts. This has been quite a week! If you were on Mars and missed the 1,000-point Dow Jones Industrial Average correction, you may find the details on the front page of every newspaper.
We have received the following frequently asked questions.
1.Are you worried about China?
Answer: Yes. China is the world’s second-largest economy. The US is first. China is the world’s largest goods-producing economy, while the US is heavy in services. China’s growth rate is slowing. Its governmental policies are changing. The transmission mechanism that took 15 to 18 million people from rural to urban lifestyles has stopped. China’s population imbalances – the result of the earlier one-child policy and the Chinese preference for male children over female – are now revealing themselves. The high economic growth rates of the past three decades, from 7% to 9%, will not continue. China is huge, and its economic slowdown is globally important.
Do we throw in the towel because of China? No. We expect more incentives and stimulus from China. Over time, we expect the Chinese currency to follow a gradual path toward floating. China wants the yuan to be a world reserve currency, and the country’s economic size supports that desire. However, a long process is required to achieve reserve currency status, and stumbling blocks can be expected along the way. China is not a reason to liquidate all stocks in the United States. It is a reason to be very selective about China exposure.
2.What about Europe and Greece?
Answer: Greece is temporarily resolved. “Extend and pretend” have resulted in a new deal. Now there will be a new government. The issue of default by Greece has been postponed for approximately three years. The issue of Greece as the weakest and most deeply wounded member of the Eurozone is still open.
Will the Greek economy actually hit a bottom, plateau, attract investment, and begin to grow? That query is fair, and its resolution is undetermined. At best, the outlook is problematic. For the next three years, Greece really doesn’t matter except to those 11 million citizens who live there and a small global business interface.
3.What about the rest of Europe, the euro, and the European Central Bank (ECB)?
Answer: The euro is destined to get weaker. In our view, parity with the dollar will happen, and long-range valuation may approach the lowest price in the post-Maastricht era. That was about $0.85. European inflation is very low. European interest rates are based on a policy of negative rates on excess reserves. The 19 countries in the Eurozone are at negative rates. In addition, neighboring countries like Sweden, Denmark, and Switzerland have negative rates. Acceptance and use of negative rates is growing.
The distortion and other impacts generated by negative interest rates set by a major central bank are extraordinary. Negative rates eventually result in higher asset prices in many places in the world, including Europe. Those negative rates are purported to be an attempt to stimulate inflation, although they do not seem to work. At best, extraction from negative interest rates will be extraordinarily difficult. At worst, it will be impossible without major dislocations. That said, Europe and the Eurozone are committed to negative interest rates. In fact, the ECB may take rates deeper into negative territory if they can find market-clearing mechanisms to do so. This is a very large economic block of 500 million people. In its entirety, it is the second-largest capital market block in the world. For investment purposes, selected countries and markets with currency hedged positions in Europe are attractive.
4.What about Japan?
Answer: We have seen the criticism of Abenomics. In Japan, we see no inflation, a continuous commitment to zero interest rates, and a decline in the growth rate. Two decades of zero interest rates and accompanying policies in Japan have resulted in some asset recovery but very little growth. Now Japan has to contend with a currency adjustment with a very serious and large trading partner, China. Our expectation is that Japan will launch additional quantitative easing, maintain a zero interest rate policy, and expand to the degree it can by means of a fiscal policy funded by monetary creation.
Will those measures bring Japan any inflation? That is unlikely. Will they provide liquidity for rising asset prices? Yes. Will the Japanese governmental system redeploy those funds into stock market investment? Yes. The Japanese already use an ETF structure and are essentially in a monetary creation scheme in which new money buys stocks. Note that new money created in the Japanese structure includes the purchase of stocks both within Japan and elsewhere in the world, including the United States.
5.What is our economic outlook here at home?
Answer: Our best outlook through this murky fish tank is that we are growing slowly in the US and gradually improving. We see 2.5 to 3 million new, nonfarm payroll jobs a year at an annual rate. We do not see robust and rising wage pressure or strong inflationary forces. We do have extremely low interest rates. All of that is likely to continue.
What does that mean for the Federal Reserve (Fed)? We have seen some mixed rhetoric coming from the Fed. One Fed president says, “We are ready to move in September,” and another says, “I don’t see us ready until at least next year.” Mixed messages coming from a central bank are disruptive and disillusioning to market agents. Markets can handle both good news and bad news. It is mixed news and uncertainty that expand market risk premia and hurt markets as they reprice the probability of outcomes.
Our best guess is that the Fed will hike rates in September, although that expectation has been put to some question as a result of the market movements this week. We do not believe the Fed would alter a policy course because of a currency adjustment in China or because of a falling oil price. The Fed realizes it cannot do anything about the oil price. It creates money, not oil. And the Fed cannot set Chinese currency exchange rates. But, the Fed does worry about asset prices and financial markets.
Now we see a market shock this past week. We do not see credit tightening, except in the high-yield Energy sector. We do not see the elements of a typical bear market such as we had in 2008 or earlier in American stock market history. The Fed examines the history of the currency crisis in 1997 and 1998, but the system has developed insulating qualities now, based upon that experience. The Fed may worry about that historical information, but it is hard to see how such precedents would alter policy based on present conditions.
We believe the Fed will hike before the end of this year, most likely at the September meeting: they have no reason to wait. In fact, waiting would send a message to the markets that members of the Fed were more worried than markets believed them to be. The risk does not lie in the Fed’s implementing a single hike and letting markets reckon with the fact that you can move away from the zero bound and the world will not end. The risk lies in doing nothing.
We expect the Fed to hike to 50 basis points on IOER (interest on excess reserves) before the end of this year. We will learn more when Fed Vice-Chair Stanley Fischer speaks at the Jackson Hole meeting. He has recently been placed on the program after earlier iterations of the program lacked a speech by Chair Yellen. If Yellen were now to speak after not having scheduled an appearance earlier, the markets might roil over uncertainty and the Fed’s attitude. So Fischer now has to carry the message. Clearly, the Fed has decided that a message is needed, and the Fed has selected the Jackson Hole meeting to deliver it.
6.What is your favorite sector?
Answer: The Utilities sector. We continue to be at maximum overweight in that sector, a position we have sustained for quite some time. In fact, we’ve had to make a round trip in terms of pricing. In one year, Utilities was the best-performing sector. At the beginning of the next year, utilities corrected and were hurt. We stayed favorable through this entire course. The Utilities weight in the S&P 500 Index is at a low single digit. In our US portfolio models it is at a low double digit. Our Utilities position weights in some portfolios exceed 10% and can even approach 12%. We like a position in which the running yield is 150 basis points higher than the riskless 10-Year US Treasury obligation. At the same time, the industry as a group has a potential growth rate in the mid-to-high single digits with gradually increasing dividend payouts. Those payments are fully denominated in US dollars, as are the measurements of earnings and activities. Other sectors we like and dislike are familiar to our clients as they look through their portfolios.
Our position on the market’s convulsion this week is that this is a major correction underway and long overdue. But the long bull market is not over in our view. We expect the trajectory of stock prices to be higher and the US stock market to close at a new high before the end of this year. Our long-term target for the S&P 500 Index remains 3,000 at the end of this decade. We think we will reach the target while the US economy sustains a very gradual but improving growth rate with low inflation, low interest rates, and all the characteristics of slow recovery.
It has been a long week. The coming week will likely be the same. Markets are in the middle of rocky seasonal volatility. The Fed is the big unknown. The rest of the world looks questionable and problematic, and recidivism among the “bad guys” seems to be intensifying. What’s new?
Lastly, we are in the midst of a political “silly season.” The silly season provides a lot of entertainment. The serious work of our political process is coming, but there are still a few months before it arrives. At that time, the Democratic and Republican fields will become clearer. At this stage, the positions and roles of our political figures still are not fully known.
This is a fascinating year in American politics. How it ends up next year is unknown. We can’t yet foresee who the candidates will be or whether Sanders or Trump might undertake an independent run should either not end up as his party’s nominee. A highly speculative outcome would be two independent runs, Trump and Sanders, plus the respective nominees of the Republican and Democratic parties contending in a four-way presidential race. What a fascinating brawl that would be for American politics.
It is an exciting time to be an American. We live in a marvelous country. We watch our system unfold and reveal itself in myriad ways. It is dramatic and a source of national pride to see young American men saving people’s lives on a train between Amsterdam and Paris. Think about that action and the role Americans play in defending their country and others and protecting innocent people from threats. There are good things to celebrate even as we worry about emerging-market selloffs.