Implications of Plummeting Oil Prices

December 5th, 2014

Highlights 

  • Two prominent energy experts – Daniel Yergin of IHS and Edward L. Morse of Citi have issued reports contending the oil market is now being dominated by a much greater than anticipated surge in U.S. production since 2008. It has caught other oil producers by surprise, and the failure of OPEC to cut production at last week’s meeting sent prices for WTI plummeting below $70 a barrel — a decline of nearly 40% since mid-year.
  • Investors currently are assessing who the winners and losers are. Yergin contends the main losers are Venezuela, Iran, and Russia, and he foresees a slowdown in new energy investments around the world. U.S. companies also will look hard at their plans, but Yergin claims new U.S. production is more resilient than anticipated and should continue to increase in 2015.
  • It remains to be seen where oil prices will shake out, but the latest developments are positive for the U.S. on two fronts: (i) the price decline is equivalent to a tax cut for U.S. consumers of about $160 billion, or nearly 1% of GDP, which should propel real GDP growth in 2015 to 3%; and (ii) according to Citi, the U.S. oil import gap will be eliminated before the end of this decade, which bodes well for U.S. trade and the dollar.

Read the rest of this entry »

Dollar Worries are Overblown

November 10th, 2014

Highlights

    • The dollar has appreciated by 8%-9% against the Japanese yen and the euro this year. Thus, reflecting better economic performance in the U.S. and policy actions by the Bank of Japan (BOJ) and the European Central Bank (ECB) to combat deflationary pressures. The dollar has also risen significantly against several currencies that have been affected by falling commodity prices.
    • Worries that the dollar’s rise could weaken the U.S. economy are overstated: The trade-weighted appreciation is 4%, while U.S. trade accounts for just over 10% of GDP.
    • The dollar’s appreciation will impact U.S. multinationals’ profits via translation effects, but the loss in U.S. international competitiveness thus far is modest. Also, U.S. businesses are highly competitive today, so the consequences for the broad market should be limited.
    • Meanwhile, the dollar is likely to trend higher into 2015, especially against the euro, as the ECB will be struggling to overcome deflation while the Fed will contemplate policy tightening. Click here to read more.

Market Gyrations: Sorting News from Noise

October 21st, 2014

Highlights 

  • Volatility in stocks and bonds has surged recently following a period of calm. The common explanation is that investors are worried about a slowdown abroad, especially in Europe, where officials disagree openly about how to respond.
  • Despite these fears, the U.S. economy is not showing signs of slowing thus far, and job market conditions are improving. Weak growth abroad may affect corporate profits at some point, but lower oil prices and financing costs will cushion the impact.
  • Evidence that inflation and inflation expectations are declining around the world is more apparent and could keep bond yields low for a while longer. However, the recent gyrations in yields are largely technical in nature.
  • Our bottom line: A 10% stock market correction is not surprising following two years of steady gains, but a bear market is not in the cards, as there is little risk of recession or resurgent inflation.

Worries about Global Weakness are Exaggerated

Following an unusually calm summer, investors have worked themselves into a frenzy that the U.S. economy is vulnerable to a worldwide slowdown. However, when one looks at the batch of economic releases that have come out this month it is hard to grasp why. The recent IMF/IBRD annual meetings set the tone, as the IMF staff downgraded its forecast for global growth (once again). This was accompanied by disappointing industrial production data for Europe, at a time when officials have disagreed publicly about what needs to be done to jump start the euro-zone.  Read the rest of this entry »

Diverging Economies and Policies

October 9th, 2014

During the past quarter, financial markets were primarily influenced by a divergence in economic performance between the U.S. and U.K. economies, each of which registered solid growth, while the euro-zone and Japan remained weak. This development reinforced expectations that policymakers in the U.S. and U.K. could begin tightening monetary policies by mid-2015, while the European Central Bank (ECB) and Bank of Japan would keep monetary policies accommodative for the foreseeable future.

These expectations, in turn, contributed to a strong showing of the U.S. dollar, which appreciated by about 8% against the euro and Japanese yen, respectively, and by 6.5% on a trade-weighted basis. At the same time, U.S. bond yields rebounded off their lows, with the 10-year Treasury closing the quarter at 2.50%, up from an interim low of 2.34%, but well below the 3% threshold at the beginning of this year. Returns for the Barclays Aggregate Index were little changed for the quarter, leaving the year-to-date return at 4.1%. Meanwhile, the U.S. stock market powered to a record high, with the S&P 500 Index at one point surpassing the 2000 level, before closing the quarter near 1975, generating a total return of just under 8% for the first three quarters. Read the rest of this entry »

Assessing China Risks

September 29th, 2014

Highlights

  • One of the most important challenges for investors is to assess China’s long-term prospects. A recent analysis by a prominent China watcher, Professor Michael Pettis of Peking University, reshapes the debate about whether the economy is headed for a “soft landing” or “hard landing” and offers several insights.1
  • Pettis contends the choice policymakers confront is deciding between a “long landing” strategy, in which China’s growth is allowed to slow over several years to 3%-4% without unemployment surging, versus targeting higher growth of 6%-7% that is unsustainable and likely followed by a collapse.
  • Pettis claims Chinese policymakers understand this dilemma, but it is too early to tell which direction they will take. Conventional wisdom holds that slower growth could be socially disruptive, but Pettis contends that eliminating artificially low interest rates will transfer income from inefficient companies back to households, thereby supporting higher consumption.
  • My reaction is that the scenario Pettis outlines is plausible in theory, but it is highly questionable whether overall growth could fall to 3%-4% without unemployment surging and China’s policymakers responding. Even if his favorable outcome unfolds, the global economy and world equity markets would feel the fallout of markedly weaker Chinese growth.

Reframing the Debate about China’s Growth Prospects
Most analyses of China characterize the debate about its growth prospects in terms of whether economic growth will slow moderately to 6%-7% (the “soft landing” scenario) or more substantially to 3%-4% (the “hard landing” scenario). The prevailing view is that the former outcome is the most likely over the next few years as policymakers seek to buttress the economy. However, a vocal minority foresees the bursting of a property bubble that will result in financial disruption and much weaker growth.

Michael Pettis, a former Wall Street investment professional turned professor at Peking University, contends this is a false dichotomy. In his view, the Chinese economy has only been able to maintain 7%+ growth due to rapid credit expansion, and he believes the economy is now running up against constraints on how much debt is sustainable.

“Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing.” It is not an alternative.”

For the time being, Chinese policymakers are clinging to the official 7.5% target growth rate and are likely to deploy added stimulus should the property sector weaken further. However, Pettis is hopeful the government will eventually adopt a “long landing” strategy in which China’s growth rate is allowed to transition over time to 3%-4%, while household income grows at a faster pace of 5%-7%. If this transition can be achieved, it would imply that income is transferred away from inefficient companies back to Chinese households, thereby lessening the risks of rising unemployment and social disruption.

Implications of Ending Financial Repression
For this transition to occur, the Chinese government will have to embark on reforms to end so-called “financial repression.” This term refers to policies in which rates that depositors receive on their bank accounts are set well below market clearing levels, which enables banks to provide cheap loans to Chinese businesses, many of which are state-owned.

Pettis notes that financial repression was vital to mobilize savings in the early stages of China’s transition from a poor, agrarian based economy to a more industrial economy. Over time, however, the artificially low interest rate policies contributed to a loss of investment discipline, as inefficient firms were able to obtain cheap financing, which in turn contributed to an enormous misallocation of capital over the past decade. Pettis estimates that over the latter period as much as 5%-8% of GDP was transferred from households to borrowers, which explains why the growth in household income lagged the growth in GDP. (Note: Estimates by the IMF are within a comparable range.)

Pettis sees the low interest rate policies coming to an end, as President Xi appears committed to the process of financial reform. The official lending rate has risen to 7.5% while nominal GDP growth has slowed to 8%-9%. As a result, it is more difficult for borrowers to justify investments in non-productive projects. Also, as the resource transfer from savers to borrowers shrinks, economic growth is likely to transition from being investment-led to consumer-led. At the same time, Pettis acknowledges there are borrowers that are effectively insolvent and which may still receive ongoing support from the Chinese government.

One challenge President Xi faces is vested interests in the Communist Party that are opposed to economic reform. Pettis acknowledges this, but also notes that President Xi is China’s strongest leader since Deng Xiaoping, who pioneered the country’s transition to a more market-oriented economy. He observes:

“China is still vulnerable to a debt crisis, but if President Xi can continue to restrain and frighten vested interests that will inevitably oppose the necessary Chinese economic adjustment, he may in the next one to two years be able to get credit growth under control, before debt levels make an orderly adjustment impossible.”

My Take: Insightful but Unlikely
Pettis’s analysis is both insightful and worth considering, because it challenges conventional thinking about China. His main insight is that by eliminating distortions in capital markets, policymakers can achieve the objective of rebalancing the Chinese economy away from reliance on investments in favor of consumption, and he makes a strong case that the costs of financial repression outweigh the benefits.

That said, I find his favorable outcome, in which growth slows to 3% without unemployment rising, to be very difficult to pull off in practice. It assumes that China’s policymakers have the wherewithal to engineer a controlled slowdown, even though this is rarely the case. Consider some of the dynamics involved; when businesses are forced to cut back on spending due to lack of available credit, some will respond by shredding labor and others may become effectively insolvent, which would create strains for financial institutions. Pettis acknowledges these possibilities, but does not offer a compelling rebuttal. His scenario envisions a wealth transfer to households boosting consumption, especially of services, which tend to be more labor intensive, and he observes the government could mop up unemployed workers by putting them into make-work-jobs. At the same time, he acknowledges this response would not fundamentally address China’s debt problem, but simply roll it forward.

One issue Pettis does not discuss is the impact that substantially lower Chinese growth would have on the global economy and financial markets. Currently, world markets are priced for only a marginal slowdown in China’s economy. Therefore, if China’s growth were to be cut in half in the next few years, world equity markets would likely feel the fallout at some point, with emerging economies that have close trading ties with China taking the biggest hit.

1See Michael Pettis’ blog, China Financial Markets, “What does a “good” Chinese adjustment look like?” September 2014.

How to Better Anticipate and Manage Future Crises

September 4th, 2014

Remarks delivered at the Bretton Woods 2014 Conference: The Founders and Future hosted by the Center for Financial Stability on September 4, 2014.

Thank you for the opportunity to address this topic. It has been an area of interest for me since the 1970s, when I worked on developing an early warning system for detecting debt problems of developing countries at the U.S. Treasury and the Federal Reserve. Thereafter, I worked with financial institutions that had considerable exposures to domestic and foreign markets. My perspective is that of an investment professional whose job is to assess opportunities and risks.

I will begin by saying the task of identifying financial crises is not easy for investors. If it were, they would be fewer and less severe. For investors to do a better job in the future, they will have to overcome the following obstacles:

(1)   Lack of adequate and timely information on exposures of borrowers and lenders. The financial system appears as a “black box” for investors, and while regulatory bodies have the authority to peer inside this box, their track record of identifying potential problems has been poor.

(2)   Lack of a conceptual framework for thinking about financial crises. Until recently, they were considered to be episodic rather than systematic, and with the principal exception of the Bank for International Settlements (BIS), economists did not focus on the credit cycle and its determinants.

(3)   Lack of economic policies to promote financial stability. Investors take their cue of what matters from policymakers; consequently, if policymakers appear unconcerned about financial stability, they will be similarly inclined. Read the rest of this entry »

The U.S. Expansion: Does Slower Growth Spell Longer Expansion?

August 14th, 2014

Highlights 

  • The U.S. expansion is now five years old, matching the post WWII average duration while being considerably slower in terms of growth. Skeptics cite this as evidence that the business cycle is living on borrowed time, while optimists believe the subdued recovery will prolong the expansion. A research note by J.P. Morgan sides with the optimists and concludes that the expansion should run for another 2-4 years. 
  • Fed Vice Chairman Stanley spelled out the complexity policy makers face in a speech this week. First, they must understand why aggregate demand has been unusually weak, and whether this is temporary or ongoing. Second, they must also assess the extent to which the economy’s productive potential has been lowered by declines in labor force participation and factor productivity. 
  • The view that the current expansion is likely to be prolonged is an important component of our investment strategy. While the debate about the economy’s long term potential will not be resolved for years to come, we still expect economic growth to accelerate in the next 1-2 years, as fiscal drag lessens. If so, this should underpin profit growth and the stock market while bond yields rise. 
  • One risk to our outlook is the Fed could tighten monetary policy prematurely. However, the bigger risks are geopolitical developments that could undermine recovery in Europe and/or lead to an oil supply disruption in the Middle East. 

The Case for a Prolonged Expansion

This quarter marks the fifth anniversary of the economic expansion that began in mid-2009. Based on post-war experience in which expansions have averaged five years, the current one would appear to be long in the tooth. However, when one considers the amount of slack resources in the economy and the lack of excesses, this is less evident. Read the rest of this entry »

Markets at Midyear: Waiting for a Breakout

July 8th, 2014

Highlights

  • The first half of 2014 was unusually calm for financial markets. The main surprise was a 50 basis point drop in Treasury yields. Returns for investment grade and high yield bonds were about 5.5% each, while the S&P 500 Index posted a total return of 7% as it set a new record high.
  • Looking ahead, investors are unsure when market volatility will return. We continue to believe the most likely outcome is higher U.S. bond yields, as the economy regains momentum and inflation edges upward. Further stock market gains are likely to be moderate, considering how far the market has advanced in the past five years.
  • The main risks lie outside the United States, especially in the Middle East. The wild card is the prospect of an oil supply disruption that could boost oil prices and weaken the global economy.
  • We are moderately underweight in duration and overweight in credit risk in bond portfolios. For balanced portfolios, we continue to maintain a moderate overweight position in equities versus bonds.

Calm Markets Despite a Poor Start for the Economy

The most prominent feature of financial markets in the first half of this year is how calm they have been. U.S. stock market volatility, as measured by the VIX, is the lowest since the onset of the Global Financial Crisis in mid-2007. The market has not had a pullback of 10% or more for two years now. Similarly, corporate bond yields and spreads versus Treasuries are down to pre-crisis levels and currency markets have been unusually quiet. The main reason is that investors are comfortable with the fact that the Federal Reserve is not in a hurry to raise short-term interest rates, even as it winds down its bond purchase program.  Read the rest of this entry »

Falling U.S. Bond Yields: The Market Surprise for 2014

June 3rd, 2014

Note: Fort Washington Investment Advisors, Inc. (Fort Washington) is pleased to announce the appointment of Steven K. Kreider as its new Chief Investment Officer, succeeding Nicholas P. Sargen in the role effective May 30, 2014. After a long and successful tenure as Chief Investment Officer, Mr. Sargen will remain with Fort Washington and continue to serve the company as Chief Economist and Senior Investment Advisor.  In his role as Chief Economist Nick will continue to update his blog with current market and economic information.

Highlights      

  • Last week’s decline in Treasury yields took the 10 year yield close to 2.4%, the lowest level in a year. The move primarily reflects technical factors, as well as ongoing concerns about global weakness, especially in Europe.
  • The cumulative 60 basis point decline in bond yields this year also reflects revised expectations about U.S. monetary policy. Previously, market participants expected the federal funds rate to rise to 4.5% over the next five years; now they are pricing in the funds rate to peak at 3.5%.
  • We expect bond yields will move higher in the balance of this year as the U.S. economy regains momentum. Accordingly, we are maintaining an underweight duration position in fixed income portfolios.

What’s Behind the Decline in Yields?

Until the past few weeks, Treasury yields had fluctuated in trading ranges, with the 10 year yield centered about 2.7%. During May, the market broke out of its range, as yields fell by 25-30 basis points. The decline sent the 10 year Treasury yield near 2.4%, the level where it was a year ago. This has surprised many investors, including ourselves, considering that recent economic data suggest the U.S. economy is recovering from its first quarter slump and the Federal Reserve is continuing to scale back its bond purchase program. Read the rest of this entry »

Markets in Equilibrium: Anticipating the Next Move

May 6th, 2014

Highlights 

  • Our assessment at the start of 2014 was that U.S. stock and bond markets were reasonably priced, and their prospects depended on how the U.S. and global economy fared, and on Fed policy developments. So far, the principal surprise has been a 40 basis point decline in Treasury yields, which is an enigma for many investors. 
  • One year ago, when yields were roughly 100 basis points below current levels, they surged when the Fed announced it was contemplating winding down its bond purchase program. But it is unlikely the Fed will surprise investors again, and investors are comfortable that quantitative easing will be completed by the fourth quarter. 
  • Meanwhile, the strength of the U.S. economy is likely to be the key market driver in the balance of this year: Should the economy grow in the neighborhood of 3% while monthly payroll gains average 200,000+, Treasury yields are likely to resume their upward trend. Accordingly, we are underweight in duration in fixed income portfolios, and have closed out high yield positions for tactical reasons. 

Market Lull: How Much Longer?

Following a bond rally and stock market sell-off in January, U.S. financial markets have settled into narrow trading ranges in the past three months: The yield on the 10-year Treasury has been centered about 2.7%, while the S&P 500 Index has fluctuated around its level at the beginning of this year. The initial moves reflected investor concerns about a U.S. slowdown, as well as political and economic developments in several emerging economies. More recently, investors have shrugged off weaker-than-expected U.S. GDP growth in the first quarter, fears of an economic slowdown in China and other emerging economies, and heightened tensions over Ukraine. These developments suggest financial markets are in a state of equilibrium, which is likely to continue until there is a major market surprise.  Read the rest of this entry »