While Q3 started out much better than the very slow economy of the first half of 2016, August’s data was very weak although there was some bounce in September. So, we enter Q4 with some serious concerns about the fragile state of the economy, where an outside shock or policy mistake could have serious consequences. Unfortunately, the policy tools, or lack thereof, that are available should the economy slip into recession are a further cause for concern. The toolkit available to the Fed, especially at the zero interest rate boundary, is much more effective at restraining growth (by raising rates) than it is at stimulating it. And if anyone thinks that fiscal policy will be used effectively, they haven’t been paying attention for the last decade. It appears that, in today’s political environment, fiscal policy will only be actively used after a major crisis has occurred, like in ’09. But not for prevention.
The Legacy of Zero Rates
So, let’s start with the Fed. They, along with the world’s major central banks, have painted themselves into a corner. Zero, or near zero, interest rates appear to have favorably impacted equities, but, lately, appear to be negative for the real economy. How else do you explain the slowest growth year (2016) of the slowest post-WWII recovery. While we can’t pinpoint the exact reason for the sluggishness, we believe that some of it has to do with demographics, and some with regulations and high tax rates. In the US, for example, each year since the Recession, more small businesses have closed their doors than new ones have opened. And we also suspect that businesses are hiring part-time to avoid the Obamacare regulations; so when a worker loses a full time job and replaces it with two part-time ones, it counts in the surveys as a net positive job created, when, in reality, it is a net negative for the worker. On the demographic side, a large portion of the wealth in the industrial economies of the world is in the hands of the baby boomer generation. Because of zero rates, returns on the retirement savings and investments of this generation are inadequate. So the baby boomers keep working, holding on to jobs that would ordinarily be available to younger workers. Also, zero rates cause the baby boomers to cut back on consumption, and also to move assets to higher risk, higher return investments like equities (now with near record high PE ratios) or high yield investments (with near record low spreads to investment grade debt). The Fed now recognizes that its zero rate polices have become ineffective at further stimulating the economy, and so it has sent signals to the market that it wants to begin to raise rates. Sounds crazy in an economy where profits will be down for the 6th straight quarter, where housing can’t seem to find its legs despite many quarters of record low rates, where investment in new plant and equipment has stagnated, and where the manufacturing index actually showed contraction in August (back to slight expansion in September) and the jobs data in September, while meeting expectations, has confirmed a downshift in the trend line. Once again, the all-important manufacturing industries lost jobs (-13,000 for September on top of the -16,000 lost in August).
The Slow/No Growth World
By now, the Fed must have recognized that we now live in a slow/no growth world, as they have continuously lowered their expected real GDP growth rates, and now 2017 and 2018 are forecast at just 1.8% (remember, since the Recession, the Fed forecasts for these have been out of this world high – so you might wonder if the latest are also too ebullient!). Other major industrial economies, those of Europe and Japan, have even more growth issues than the U.S., and China has its own unique set of issues (see comments on Japan, Europe and China in the Appendix). Here is the dilemma: Playing in and with the financial markets has been a key role for the Fed since the Recession. Indeed, Quantitative Easing (QE) and zero interest rates put a bid back under the real estate and equity markets, and raising prices there (wealth effect) has been key in what we have had as a recovery. In a slow/no growth world, a world where zero and negative rates are rampant, a world where zero rates now appear to impede economic growth, but a world whose financial markets are hooked on zero, how does the Fed raise rates without causing a negative financial market reaction? In economies as fragile as what exists in today’s world, a significant financial market reaction could tip some economies back into recession.
We think that could happen, especially if the equity markets are unprepared. Prior to the September Fed meeting, it appeared that Yellen & Co. were trying to prepare markets for rising rates. Because the markets do not believe that the economy is strong enough for rising rates, downward price volatility began to appear in equities. As it turned out, the weaker than expected August jobs data kept the Fed sidelined, but, had they moved, the equity markets likely would have had more than a minor correction. So, as we head into Q4, it is our view that the equity markets are priced for perfection; that the US and world economies are fragile. Yet despite such fragility, Fed officials have continued to jawbone for raising rates in an effort to prepare markets for such an increase in Q4. Whether or not the markets are prepared for the increase is anyone’s guess, but if they are not, then even an increase as small as a 25 basis points in the Fed Funds rate could cause an equity market correction, like the one we had in the aftermath of last December’s rate hike. Depending on the size of any such correction, it is possible that it, alone, could be a triggering event for a recession. Even the economics profession currently has the odds of a recession in 2017 set at 30%, so, this is something for investors to be wary of.
Economic and Investment Implications
Unless there is a dramatic upswing in economic activity, which we don’t see, there appears to be more downside risk to equities than upside. Of course, a continuation of zero interest rates will keep money in dividend paying equities, but under those conditions (continued zero interest rates), economic growth will continue to be the major issue. Eventually, an external, recession causing shock will occur. There are significant implications of a slow/no growth world for investors. In a faster growing world, equity indexing worked, as a rising economy lifted all indexed portfolios. But, in a slow/no growth world, portfolios that are indexed are going to go nowhere. After all, if there is no general economic growth, then if your portfolio is indexed to that, it won’t grow either. And, depending on the expenses charged by your advisory firm, it could actually have negative long-term performance. The only way to grow is to select growing companies, not an index which includes the low/negative performers. If you don’t have time to do that yourself, you need someone who does that; not someone who simply diversifies your assets into various indexed asset classes. On the fixed income side, no matter what the Fed does, it only impacts the short end of the yield curve. Because the world is awash in the supply of everything from labor, to productive capacity, to oil, energy and commodities, it is deflation, not inflation, that dominates the economic landscape. In a slow/no growth world, no matter what the Fed does, long-term rates aren’t likely to rise. In the faster growing world, you wanted to keep your fixed income allocation in short-term bonds. That protected you from principal losses as rates rose (i.e., interest rate risk) in a frothy economy. In a slow/no growth world, your fixed income portfolio has much lower interest rate risk, and may not be endangered if its duration is somewhat longer than what you have become used to.
Robert Barone, Ph.D.
Japan has been in and out of recession since 1990 and is the poster child for demographic issues (baby boomers). Unlike other nations, Japan relies almost exclusively on its inadequate native working aged population to support a large and growing retirement aged population. That native working aged population is actually shrinking as the retirement aged population grows. It isn’t rocket science to figure out that no matter what the Bank of Japan has tried, the economy remains stuck in zero growth gear.
Europe has its own set of problems from an increasingly hostile Muslim population, to an inadequately capitalized banking system, to ‘Brexit,’ to growing dissention in the European Union (EU) over heavy handed rulemaking in Brussels. The latest absurdity is the EU contention that Ireland acted unfairly in attracting businesses (like Apple) – clearly referring to Ireland’s low corporate tax rate. Europe’s major problems, however, are more immediate – their banking system is grossly undercapitalized. If Deutsche Bank is forced to pay the $14 billion fine levied against it by the US for its behavior in the pre-Recession period in the mortgage backed securities market, it may end up being insolvent. Deutsche was unprofitable in 2015 and looks to be so again in 2016. To add insult to injury, Deutsche is being investigated for transactions with Russian nationals in violation of sanctions imposed on the Soviets. Deutsche is likely to need government aid, something the EU has resisted, most recently when asked by Italy’s PM Renzi to allow the Italian government to aid Italy’s failing banks. Other large European banks also have issues with the US including RBS (Royal Bank of Scotland) which is 73% publicly owned and which hasn’t been profitable since the Recession. RBS, Barclays and UBS, all major EU banks, all are facing stiff US fines. On top of all of this, the ECB has such a massive bond buying program (€80 billion/month) that it has monopolized the supply of government bonds and is now purchasing corporate debt, leaving slim pickings for the private sector. No wonder Europeans are flocking to the U.S. fixed income markets. All in, with all of these impediments, Europe’s potential economic growth is likely a lot less than that of the sluggish US.
China has its own set of problems. Its 6.5% growth rate looks okay on paper. But this is much lower than the double digit rates it spawned in the immediate post-Recession period. Not all is well in China. It sports much of the world’s overcapacity in the heavy industries and those industries are still subsidized. This is one of Donald Trump’s pet issues, as they dump these subsidized products in the US, sometimes at below the US cost of production. China’s banks, too, like those in Europe, have huge issues; in China it is in their real estate loan portfolios. The banks are state controlled, so transparency into their finances is and has been an issue. The government’s attempt to move China from the world’s largest exporter (the heavy industry overcapacity) to a consumer based economy has begun, but this is going to take years, not months. Even if the 6.5% growth rate is real, China isn’t going to contribute much more to worldwide economic growth in 2017 than it did in 2016.