The global stock markets acted surprisingly well last week to a steepening yield curve as investors recognized that the global economies are improving, albeit slowly, and fears of deflation had abated. Clearly, there is a change afoot in asset allocation, with money moving out of bonds into other asset classes. The stock market rally halted on Friday after talks between the ECB, IMF and Greece broke down Thursday night without a deal. Stock markets fell and there was a flight to quality in bonds, boosting prices of all government securities. I believe that after any resolution with Greece, all markets will rally after realizing that the problem will be contained with limited, if any, contagion.
Market pundits are remaining cautious regarding the global economies and all financial markets. Calpers seems to also hold that view, as it announced that it is cutting back over half its outside managers to reduce costs and become a closet index fund. I find it interesting that Calpers and other sponsors hired hedge funds after the market crash eight years ago, underperformed for the last seven years and are now cutting back just when we are entering a time when active managers will outperform during a period of change in asset allocation and industry emphasis. By the way, Calpers is hoping to save 20 basis points. Not too much in the scheme of things, but a lot if you can't perform on the top line.
I have a feature article coming out in Hedge Fund magazine this week entitled "Maintain Perspective At All Times" in which I discuss why a successful manager must be connected to his core beliefs at all times as he filters daily events, which may be challenging. I mention my beliefs about this market, which I have enumerated a few times before. I added the following to that list: 1. Commodity prices have bottomed for this cycle; 2. Governments and corporations need to focus more on the long term and implement policies and programs to increase global competitiveness while improving the general standard of living; 3. The bull market in bonds is over and global yield curves will steepen; and 4. Don't fear fed policy, as it will remain unusually accommodative.
I liked what Larry Summers said about the current Federal funds rate. He mentioned that if a professor at Harvard posed the question "What should the Federal funds rate be if the economy was growing 2% to 2.5% and inflation was 1.5%?" If he answered 0 or near 0, he would fail. That says it all. The funds rate, just like the bund beneath 0.5%, is ridiculously low and needs to be normalized. Normalized does not mean tightened. Everyone is focusing on the supply of funds when it is just as important to understand and quantify the demand for funds. As I have said, we have entered a new period of conservatism where government deficits are declining, corporations are matching capital spending with depreciation and generating substantial free cash flow and individuals are saving more and spending less. All of this means money creation will continue to outstrip demand, which is beneficial for financial assets.
Let's take a look at the events and data points by region last week and compare them to our beliefs and conclude with an investment outlook and possible asset allocations:
1. There was a lot of positive news out of the United States that allayed fears that the economic weakness over the last six months would persist: 1. Producer prices rose 0.5% for the month, but up only 0.1% excluding food and energy; 2. Americans' net worth rose to a record $84.9 trillion dollars, up $1.2 trillion in the first quarter; 3. Household debt as a percentage of disposable income fell to 106.5%, the lowest level in a decade, while overall borrowing rose only 2.2%, the lowest in two years; 4. Retail sales rose 1.2% in May following a revised gain of 0.2% in April; 5. The budget deficit fell to $412 billion, down from $491 billion a year earlier (impacts demand for funds); 6. Small business optimism index rose to 98.3; and 7. Job openings exceeded hires for the first time ever, putting pressure on wage gains. On the other hand, the Business Roundtable, which includes business leaders, is more pessimistic and has reduced plans for hiring, wage gains and capital spending for the remainder of the year. In addition, the consumer comfort index fell again for the ninth straight week, the weakest reading in 8 months.
All of this is consistent with our belief that the economy is improving, albeit slowly, after a weak six months. By the way, first-quarter GNP will be revised upward based on the recent trade and other recent data points. We expect the Fed to lower its prior forecasts for GNP, inflation, jobless rate and the Fed Funds rate. But that does not mean that the funds rate should be this low.
2. The focus in the Eurozone remains on Greece and the fear of default rose after talks broke off between all parties last Thursday. There appears to be three paths at the moment: 1. Greece and the ECB/IMF reach an agreement; 2. There is an impasse and Greece defaults; or 3. There's a technical extension, essentially kicking the can down the road. It's time that this matter is put to bed one way or another so that we can focus on the larger issues impacting the global economies and the countries in the Eurozone. If the Eurozone wants to be a successful force, there is a need for regulatory and financial union to go with a common currency. This structure just does not work.
Greece is overshadowing the news that the European economies are showing life. The German bund yield rose to over 1% on Thursday as optimism had set in that the European economies were really improving, only to fall on Friday as investors wanted safety if Greece and the ECB/IMF could not reach a compromise.
Two other noteworthy events included the French prime minister proposing major changes in the labor laws to enhance global competitiveness and S&P's downgrading of the U.K. to negative, citing risks of the country's potential withdrawing from the European Union.
3. All signs point to further accommodation in China to support economic growth. Despite an improvement in industrial production in May with a gain of 6.1%, it is a far cry from the government forecast for growth this year of 7.0% to 7.5%. Our forecast remains at 6.5%, which any country would like.
Comments out of Japan last week were interesting as a Bank of Japan member talked about diminishing returns and the potential drawbacks of maintaining QE too long and added that it was time for regulatory and fiscal reform to promote growth and fiscal discipline. He saw little downside for the yen, which immediately rallied 2%. The economic outlook for Japan continues to improve and I expect further gains as consumer spend more now that wages are finally increasing and corporations increase capital spending to meet both domestic and foreign demand.
4. Oil prices have stabilized around $60 dollars per barrel despite an increase in the global demand forecast and a decline in inventories reported for the week. Inventory levels are still over 20% higher than a year ago. It was interesting to note that U.S production hit 9.6 million barrels per day in May, a 43-year high and up from 8.4 million barrels a year ago. I believe that oil prices overshot on the downside as panic set in and are trading at an appropriate level today and will increase further only if demand growth outstrips supply, reducing inventory levels.
Let's wrap this up.
It's ironic that the yield curve has steepened, reflecting stronger growth and faster inflation just when the World Bank cut its 2015 global forecast by 0.2% to 2.8% for 2015. It identified specific weakness in Brazil, Russia, Turkey and many other developing nations while acknowledging that strength is building in the United States, Europe and Japan. The World Bank also mentioned structural weakness will restrain global growth going forward, while at the same time, it maintained its growth forecast for 2016 at 3.3%. Global bank regulators met last week and are proposing added capital rules to mitigate interest rate risk for banks, further limiting lending capabilities and restricting growth.
The bottom line is that the worst of the global economic weakness is behind us, but the rate of gain in the future will be less for all the reasons that we mention week in and week out. But that is good for financial assets. Bonds will lose their luster as the yield curve steepens and there will be a rotation in the stock markets to companies that will benefit from the acceleration in global growth—those with strong management and sound long term strategic objectives. We are managing risk by maintaining ample liquidity at all times and by owning the best managed companies that will thrive no matter what the economic environment may be and are yielding over 2.5%.