Global growth is poised to accelerate in the second half of 2014 after a weak first half, but intermediate term (2-5 years) growth potential is declining.
GLOBAL GROWTH IS POISED TO ACCELERATE IN THE SECOND HALF OF 2014 AFTER A WEAK FIRST HALF, BUT INTERMEDIATE TERM (2-5 YEARS) GROWTH POTENTIAL IS DECLINING
- UNITED STATES - Fundamentals are improving in a longer but less robust business cycle expansion
- EUROPE - Slowly but surely exiting recession despite choppy economic data and deflationary scares
- JAPAN - The economic plan in place is the right prescription for increasing GDP (Gross Domestic Product) and combating deflation
- CHINA - Engineering a deceleration through a normalization of the “internal investment vs. consumer consumption” tradeoff and positive economic reform
- EMERGING MARKETS - Continue to be a long term global growth driver and not a systematic risk despite a short term slowdown in growth
CONTINUE TO OVERWEIGHT EQUITIES WHICH REMAIN FAIRLY VALUED ON IMPROVING MACROECONOMICS & RELATIVE VALUATION VS. FIXED INCOME; ALTERNATIVE ASSETS REMAIN NECESSARY BY ADDING NON-CORRELATED RISK-ADJUSTED PERFORMANCE
The global equity market’s performance in the second quarter was much less volatile than the first quarter with the MSCI All Country World Index higher by 5.02% and 24.09% over the trailing twelve months. Central bank monetary policy in many developed/advanced economies remains highly accommodative, and the year-to-date performance of 6.57% for global equities is noteworthy in the face of a range of market concerns. These concerns spanned volatile emerging market economies, geopolitical flare-ups in the Ukraine and Iraq, the economic impact of a brutal winter, and growing anxiety about the Federal Reserve Bank’s ultimate monetary policy intentions. We are thinking about the last two the most these days.
The first quarter U.S. GDP report (originally released in April and revised twice in May and June) was surprisingly weak at -2.9%, and global GDP in aggregate was also lower than expected. The true impact of the cold weather on economic activity is obviously unknown, but so far recent economic data suggests improved GDP growth for the second quarter, due to be released on July 30th. High quality and highly predictive leading economic indicators suggest solid GDP growth in the U.S. over the balance of the year supported by diminishing fiscal spending constraints, an improving employment picture, and a better consumer finance profile. However, the lack of meaningful economic contributions from housing, corporate capital expenditures, and global trade activity—all poor performers during the first quarter—may keep a lid on reaching full economic potential. With the U.S. contributing almost 20% of global GDP, we also expect worldwide GDP to improve as well.
Given a relatively weak economic growth outlook in the US, it is hard to worry about the Fed raising rates anytime soon…but we are still worried as the Fed continues to make progress towards achieving its “dual mandate” of maximum employment and price stability established by the Federal Reserve Act of 1977. The unemployment rate continues to decline toward the seemingly mythological level of full employment (i.e., employing 95% of the available and participating workforce), and inflation, which has not been anywhere near problematic for a long time, is approaching the Fed’s 2% target level. The dual mandates are related to each other since full employment is synonymous with inflation caused by wage growth. The crux of our worry is that the Fed will raise rates too early and/or too much in response to improving employment and cause a premature end to the current longer than average, but less robust business cycle. We would expect both U.S. and global equities to decline if it appears the Fed will act ahead of expectations. Only when the economy achieves “escape velocity” and can grow around 3% over the intermediate term, will meaningfully higher interest rates and higher equity returns be expected.
Fixed Income performance was solid again in both the second quarter and year-to-date time periods: the Barclays US Aggregate Bond Index was up 2.04% for quarter and 4.37% for the trailing twelve months. Given the downshift in global economic growth and rising geopolitical risk during the first half of the year, interest rates remain low relative to the start of the year e.g. the 10-year U.S. Treasury bond yield was 3% in January and is currently just over 2.5%.
GLOBAL GROWTH IS STILL POISED TO ACCELERATE
We monitor a focused set of global leading economic indicators that cut through the economic noise and short-term anxiety in order to continually gauge our position in the business cycle. Our quarterly review of the economic trends in key geographic regions helps frame our portfolio asset allocation decisions and has generally remained the same from last quarter:
Despite financial punditry to the contrary, the Fed created financial and monetary conditions to stimulate growth and stem financial system failure (QE1), prevent deflation (QE2), and, most recently, to offset severe fiscal tightening (QE3). Leading economic indicators suggest economic momentum remains positive, though a continuation of first quarter weakness in net trade exports (exports minus imports), inventory investment, and fixed capital investment remains a concern. The next recession continues to appear to be far off, and a sustained but mild business cycle expansion may continue considering employment and inflation are still somewhat below the Fed’s target. It is extremely rare to enter a recession when we do not have direct monetary tightening: out of the 19 recessions since the inception of the Fed Reserve Bank, there has been only one (1945, due to fiscal WWII demobilization) that was not associated with direct monetary tightening.
Slowly but surely the continent is exiting recession despite choppy economic data and deflationary scares. The region is emerging from its 18-month recession and leading economic indicators suggest economic momentum is present. However, the recovery still lacks robust and important growth drivers such as strong consumption, improved fixed capital investment, and better external trade. Add help from the European Central Bank in the form of increased monetary accommodation, and the economy will get the support it needs until it is fully healed.
“Abenomics,” the economic plan underway in Japan, appears to be the right prescription for improving the economy and combating deflation. The prescription calls for aggressive monetary stimulus, increased public infrastructure spending, and currency devaluation to make exports more attractive. Leading economic indicators continue to point in the right direction, while monetary and financial conditions remain easy and, as a result, bank lending is finally improving and providing growth capital to the economy. Long term forward corporate profit estimates and inflation are picking up, but a weaker currency has not resulted in increased exports over the last two quarters, and it is something we are watching closely.
By engineering an economic deceleration through the normalization of government investment vs. consumer consumption tradeoff and positive economic reform, the country has so far averted a hard landing during the recent global slowdown and now appears to be free of a major financial crisis. Recent fears around ongoing economic reforms in its transition to a more market-oriented and balanced (consumer spending replacing government spending) economy are valid in our opinion. Economic news flow has improved since the beginning of the year; however leading economic indicators suggest lackluster intermediate term (2-5 years) economic growth. This can pose difficulties for the government in maintaining the momentum of economic reforms in 2014 and beyond. In contrast to the rest of the world, but appropriate for its business cycle and economic evolution, monetary and financial conditions have tightened.
We believe emerging markets remain a driver of long term global growth despite a short term slowdown. The emerging markets sector is projected to account for 70% of global growth by the end of the decade given improving productivity and demographics. All major developed economies are moving in the right economic direction for the first time in a long time, and this will ultimately benefit emerging markets, which are commodity and export oriented. However, as emerging markets continue to adjust their sovereign balance sheets as a consequence of depreciating currencies, inflation concerns, and higher global interest rates, a downshift in short term growth can be expected.
Remain Overweight Equities vs. Fixed Income
Our asset allocation positioning remains overweight equities vs. fixed income. Equities in aggregate today are fairly valued relative to our forward growth projections, but they are still inexpensive vs. fixed income. Still, we are reducing both our equity and fixed income weightings and adding to our alternatives and cash positions as described below. We are disciplined in our asset allocation methodology and will only choose attractive investment opportunities that meet our rigorous valuation criteria.
We continue to reposition our overall global equity allocation based on both our macroeconomic outlook and the relative valuation opportunities in the asset class measured by valuation (price-to-earnings (P/E), price-to-book value (P/B), and price-to-cash flow (P/CF)), quality (returns on invested capital (ROIC), returns on equity (ROE), and returns on assets (ROA)), and growth (5-year forward earnings growth projections).
We continue to be mindful that an improving economy, over time, leads to an increased level of employment; more jobs = more wages = more spending on goods and services = more inflation. The perceived outcome of this relationship will cause interest rates to go up, not down, as the Fed will inevitably raise rates to combat inflation. Fixed income prices have an inverse relationship to interest rates so as rates rise, bond prices will fall. In order to protect our fixed income portfolio in this environment, we continue to prefer lower portfolio duration (duration is a measure of interest rate sensitivity) and increased exposure to opportunistic areas that have solid total return profiles. However, we now believe the eventual rise in interest rates will be lower and take longer than our expectations at the beginning of the year.
We remain committed to alternative assets such as Hedge Fund Trading Strategies and “real assets” (such as Commodities, Infrastructure, Natural Resources, and Real Estate) that have lower correlation to equity and fixed income, increase portfolio diversification, and may help protect against rising inflation.
The portfolio changes outlined above will vary based on the individual investment objectives of your financial plan. As always we very much appreciate the trust and confidence you place in our firm. We value that trust every day and will continuously strive to retain it. Please do not hesitate to contact your Advisor for any questions or service needs.
Barclays Capital|Bloomberg|Federal Reserve Bank|MKM Partners|Morgan Stanley Capital International Indices