Nothing moves markets more than when the heads of both the ECB and Federal Reserve Board speak about monetary policy and the economy. It certainly happened this past week!
After comments by ECB President Mario Draghi about the accelerated pace of QE prior to summer, the European interest rates fell; the interest rate differential with the dollar widened again, the euro fell and European stock exchanges rose. We reversed course immediately and sold our euro long position at 114 to the dollar after having forecasted a counter trend rally in the euro at 104 to the dollar and went long the European bourses, which we had sold earlier, too. The euro ended the week below 110.0 to the dollar and the markets rose nearly 4 percent by week's end.
The Fed's beige book came out on Wednesday and Janet Yellen made a speech on Friday, which both reinforced what we said Wednesday in a blog titled "Fed Needs To Get On Board." We believe that the Fed is behind the times, not the curve, and that the economic recovery will remain sluggish by historical standards due in large part to the impact of higher capital ratios on financial institutions on lending, increased federal and state regulatory oversight, an anemic recovery overseas, a strong dollar penalizing exports, a drop in energy capital spending, and a total lack of confidence in our government to make needed changes in the tax code, transfer payments, education and other non-discretionary costs. All of these headwinds mitigate to a large degree easy monetary policy and lower energy prices. Wake up Fed! Talk of tightening now to stem fears of speculation in the financial markets and to show that the Fed really understands the need to reduce its balance sheet is just plain foolish. The change in the long-term outlook for the U.S economy is not "transitory" just as the decline in energy prices will not be "transitory," as the Fed has said. Change is in the air.
What keeps me up at night is trying to better understand why our economy and other economies of the world are not performing better, especially after such mammoth monetary easing virtually everywhere. My conclusion is there is a total lack of confidence in governments to fully recognize the real impacts of globalization on their domestic economies and to make the needed changes to regulatory and tax policies to create an environment to better compete, to create higher-paying jobs, while still paying for the needed benefits and living environment mandated by society. Just look at the job participation rate in the United States. What is that telling you? It is telling me that the real unemployment rate is over twice the stated level and far, far above what Yellen calls a trigger point to begin lift off, as she says. Something is not right at the very core.
This cautious mood that permeates society here and abroad has led to a conservative bias at all levels: governments can't overspend even for needed infrastructure projects, better education and healthcare; corporations are cautious and don't trust government, so costs are contained and capital spending kept at or below depreciation, and the individual just plods along trying to just sustain themselves while not taking any undue risks and adding to his debt load. While this may sound gloomy, all of this happens to be good for financial assets over hard assets for reasons I've enumerated. My fear is lack of growth, not too much growth. My fear is stagnation, not inflation.
The key investment decision always is to have the right asset allocation and look for positive or negative change while controlling risk levels by maintaining ample liquidity. All of this is pretty straightforward. Stop trading and look for the longer-term trends and invest accordingly. Also be willing to change if events dictate, like I did this past week on the euro and European bourses.
Now let's look at each region and highlight what is happening with an eye to the future:
1. The Fed minutes and Yellen's speech tell us that Fed policy is on hold for now, a position that will change based only on future data points. The Fed keeps repeating that future rate hikes will be gradual and need not be on a regular basis, as in the past. It is clear that the domestic economy will improve after a dismal first quarter, but the rate of gain may not live up to earlier forecasts. Most of the economic data reported last week came out on the weak side and second-quarter growth may not exceed 2 percent, up from a flat first quarter. The one area of concern reported last week dealt with the increase in the monthly CPI, which came in up 0.3 percent, excluding food and energy, and up 0.1 percent overall. The year-over-year numbers were better up 1.8 percent and down 0.2 percent, respectively. While leading indicators rose in April to 122.3 and housing starts rose to a seven-year high, consumers' expectations fell dramatically to 44, which does not bode well for overall consumer demand. Net, net, the U.S. economy will improve, but not as fast as anticipated; don't worry about inflation, as there is plenty of slack in the economy.
2. Draghi and the ECB comments about front-loading QE before the summer, debate about austerity between Germany and the other G-7 members in Dresden and the endless discussions about Greece dominated the news out of the Eurozone. While economic results are improving for sure, the rate of gain has slowed appreciably and there is added concern that growth in the Eurozone will remain sluggish at best for the foreseeable future. Unemployment remains stubbornly high and is a concern. It is crystal clear, as mentioned before, that a common currency is not nearly enough and that the Eurozone needs financial and economic union, too, to be competitive in the world. Easier said then done. The euro fell sharply last week, interest rates declined and the stock markets rose sharply.
3. What will happen to Greece is anyone's guess, but I still believe that the risk of contagion in case of a default are next to nil and that contingency plans are in place and ready to go. Every week seems to have a new drop-dead date. Now it is June 5-19, when Greece has payments due to the IMF. This is akin to a Greek tragedy. Let Greece go already and let's return to normalcy in Europe. Greece will be forced to make the right decisions for its people and will survive. But it will be painful.
4. China and Japan continue to make the right policy moves to better compete and build a stronger foundation for the future. It appears that each government is leading its own circle of allied countries in the Pacific Rim. Japan has the direct support of the United States, which recognizes China's competitive threat extending beyond the Pacific region.
While economic stats out of China remain sluggish as policy changes are enacted, economic results out of Japan continue to be surprisingly good. Both stock markets continue to hit new highs and I am optimistic about both countries, as I am on India's future.
5. One has to be concerned about the political unrest throughout the Middle East. The United States has totally lost credibility in the region and it will be interesting to watch what happens with the nuclear pact with Iran. Our government needs to walk the walk and act to protect our friends in the region. At the same time, our governments needs to support programs here for energy independence and offer incentives from top to bottom to increase domestic production and increase energy efficiencies while reducing pollution. Seasonally, inventory levels are drawn down in the late spring as we enter the summer, which should support oil prices around this level. If prices rise much above $60 per barrel, expect many short-term projects that have been delayed to start up again, capping any further price gains.
6. No one said that investing was easy, especially when you are bombarded with so much news and information to analyze. It is hard sometimes not to react, but the truth is that successful investing takes patience, conviction and the willingness to change.
While I firmly believe that the global economy is improving, I am disappointed by the rate of change for all the reasons discussed above. Growth will be less in the future, the highs will be lower and the lows will be higher, global competitiveness will keep inflation and interest rates contained and if the Fed does begin to raise rates in the late fall or in 2016, the increases will be small and far between and from an incredibly low base.
I do not want to hold any bonds in my portfolio as I see no upside in price and I can get better yields and returns elsewhere with minimal risk. I still believe (unlike hte pundits) that our stock market has considerable upside, as the market multiple should be close to 19-20 times projected earnings based on a 2.50 percent 10-year bond (2.20 percent today) and a risk factor of only 2.5 due to significantly reduced systemic risk. The surprise is that S&P earnings will do better than projected, as corporations are doing a good job of holding down costs and improving overall profitability. Free cash flow is rising, money that can used for higher dividends and buybacks after further debt repayment.
I have made only minor changes in my portfolio. I am investing in companies making strategic changes to improve their growth rates, competitiveness and returns on capital while shorting those that are maintaining the status quo. My holdings begin with Alcoa and end with United Technologies. I see tremendous opportunities out there and only hope that governments here and abroad can do what is needed to improve their economies and create good jobs while improving the quality of life. It can be done. I know it.