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Question of the Week - June 1, 2015

Question of the Week - June 1, 2015

Guest Post - Monday, June 01, 2015

There hasn't been much votality for a while. What's 'out there' over the summer to keep an eye on?

There's plenty behind the scenes, as usual. Here's a snapshot of some key issues.

The Fed. This has to be one of the most closely-watched potential rate increases in history. We’ve noted before the 'old school' Fed tendencies of decades past—notably the lack of publicity and transparency concerning direct open-market operations. Even when announcements evolved to be more up-front and granular, communications were nothing like today's world where every word of every statement and FOMC member speech is hyper-scrutinized. But, despite all this, we're back at the same place—the Fed is moving methodically and the decision is 'data dependent,' implying that rates will only be moved higher when underlying growth, inflation and labor markets look to be self-sufficient to an obvious degree. A few quant models that measure inflation vs. policy targets, actual vs. potential GDP, among other factors, in order to determine an appropriate rate, still show a result of near 0%. But, these are naturally very sensitive to estimated inputs. What the Fed looks to as a worst-case model (rightly or wrongly) seems to be the late 1930's, where a recovery was deemed in place and rates were hiked too soon—causing a secondary recession. Best guesses are that June is out, but Sept. or Dec. are still in play for a possible rate hike. The Fed's credibility is also on the line a bit, the longer this goes on. However, there is really nothing new here.

(Relatively) Slow Economic Growth. This is related to the prior paragraph in that the economy isn't running as quickly as economists have hoped for this year. The first quarter was a disappointment—being just revised into the negative—but this was blamed on bad weather, port strikes/slowdowns, insufficient seasonal adjustments, etc. The second quarter is expected to be much better, partially due to a common bounceback effect, but concerns remain about the robustness of consumer spending, a tentative pickup in housing, and the persistence and impacts from lower energy prices.

The Dollar. Strength of the dollar was another factor blamed for the poor economic showing of the prior few quarters—with the direct impact being lower net exports (as exporters are at a disadvantage in a strong dollar situation). The strength that almost entirely occurred in the 2nd half of 2014 through March of this year has dissipated in recent months before finding more signs of life in the last week or two. The Fed is keenly aware of the dollar's impact on the economy, and while dollar stability or, more directly, 'avoidance of excessive strength' isn't part of the official mandate, it could seep into policy. Rate increases sooner than later (vs. other developed market currencies) are likely to perpetuate strength, while weaker data and postponed increases could keep the dollar's rise at bay—but currencies are tricky to diagnose.

Oil Prices. This is the primary market disruption from late 2014 on, and while pricing has stabilized somewhat lately to the $60 range with less volatility, a variety of aftereffects remain. One is that the perceived usual tendency for consumers to 'save' their windfall from cheaper oil prices didn’t happen as planned—partially because quick volatile moves cause distrust in their long-term sustainability and the fact that gasoline didn’t cheapen as much or for a long as crude oil did. Gasoline prices are a key factor in consumer sentiment as we’ve pointed out from time to time. Longer-term, though, cheaper oil acts as more of a positive than a negative for consumer behavior, although it takes time to filter through (quarters, rather than weeks). On the downside, the U.S. shale boom has suffered some hits from lower pricing, as margins have compressed (compared to extremely cheap extraction costs in the Middle East), so cuts in capex, rig counts and jobs have offset some of the benefit, but perhaps not to the extent some have feared. Supply remains high, and this has been a continual overhang on energy markets, with hope that improved global growth will offset some of that with higher demand.

Grexit. This ongoing drama continues, as Greece is scrambling to find funds needed to satisfy upcoming debt payments—several of which are in June—so expect more tough talk and market response. This comes down, as it always has, to two camps. The European core (Germany, mainly) feels Greece should be compelled to continue austerity measures as a condition of fulfilling obligations to remain a member of the Eurozone, and the Northern populace is growing tired of serving the role of a bottomless piggy bank. On the other hand, the Greeks feel they have suffered enough, have implemented critical reforms, but can only do so much without sacrificing any ability to achieve sustained long-term economic growth and appease an increasingly frustrated population. Angry citizens are historically unpredictable, and while the majority (via survey) appear to value Eurozone membership, continued hard times have and could result in further political change, rendering negotiations with the rest of Europe more difficult and/or impossible. Chances of a Greek exit from the Eurozone now seem to vary up and down from 50/50; the good news is that the longer this goes on, the more tired markets may get of the story, further pricing in a bad outcome, and perhaps even sparking a rally on the news of a final resolution. Stranger things have happened.

Market Valuation. This is a challenging time for asset allocators. While equities are certainly no bargain, a la 2009, they aren't pushing 2000 levels, either. Large-cap blue chip U.S. equities are hovering around 'fair value,' or just above it. It’s important to remember what 'fair value' really is—it's the typical valuation one would expect given long- and nearer-term growth rates, at current interest rates and risk premiums. Therefore, long-term average growth should be expected (reminder: not a bad outcome!). We are, however, perhaps overdue for a pullback of some sort, whether it's 5% or 10%, and of course the catalyst for such a thing could be anything. The opportunity cost of course is that earnings improve and risk assets move higher by continuing to climb that ever-present 'wall of worry.'

Bonds. This is related somewhat to the Fed discussion above, but bonds are in a tricky place today. From a 30,000-foot overhead view, the 1982 rate peak to today represents an almost-35 year bull market in fixed income, with returns much higher than long-term term historical averages (+7.8% from 1982-2014 compared to +5.3% for 1926-2014, average-annualized, for intermediate-term government bonds, per Ibbotson). Various financial planning software packages have struggled with this—and when you see bonds with expected returns matching those of equities, you know you have an expectations problem. Bonds deserve a place in a portfolio for income, and as a 'flight to safety' cushion against volatility in other asset classes—but sky-high returns shouldn't be part of that equation. At the same time, there are attractive areas in credit that can provide perhaps better returns than Treasuries, such as high yield, floating rate, foreign debt, etc., and these have all been useful in our recommended portfolios for many years. Additionally, making adjustments (as we have) for avoiding unnecessary interest rate risk is also prudent and can provide help with relative returns if long-term bond returns eventually mean-revert to average returns or worse.

China. Conditions matter here since a bulk of global growth now originates from China—the largest member of the emerging market group. While GDP growth figures are debatable and not often precisely accurate, we know growth has slowed, albeit built on a much larger foundational base than years ago. This isn’t surprising as an economy’s maturation from the 'easy' growth stage of building factories and infrastructure into a higher status of more 'services' is more difficult to come by. In recent years, the debt incurred to boost this growth has been of concern, as is government policy to ensure a 'soft' as opposed to 'hard' landing, the absorption of internal debt defaults and effects of this slower growth on other nations. Commodity markets, namely industrial metals, for example, have felt the pinch, as construction has slowed.

Geopolotics. This is the kitchen sink including any number of issues. In recent years, it's been the Russian incursion into the Ukraine, rumblings in Iran or other areas of the Middle East and ISIS' military aggression in Iraq. While a market-moving event is unknowable as of yet, if serious enough, it can always be the catalyst for pullback and, if severe enough, past experience tells us it could keep interest rates depressed for longer through higher flows into risk-free assets that prop up government bond prices.

In fact, after noting the items above, we encountered the results of a poll conducted at a Deutsche Bank global investor conference—highlighting the following biggest possible financial market tail risk events for the next few years (in order of votes gathered): China growth under 5%, withdrawal of the Fed balance sheet (i.e. removal of all QE), the Grexit and oil prices rising above $100. The first two were much more popular than the latter as risks, but reiterates current consensus thinking. Contrarians, however, might choose to disregard all four

Additional Reading

Read our Weekly Review for June 1, 2015.

Read the previous Question of the Week for March 26, 2015.

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