Focusing on the Three Ds

Looking forward several years, there will be three important factors that will determine the economic and investment outlook. They are decoupling, deflation and demand. The decoupling concept is based on the question, “Can the United States economy expand at about 3% if the rest of the world is in recession or experiencing diminished growth?” The deflation concept is supported by the decline in the price of oil and other commodities, plus the willingness or necessity of the unemployed throughout the world to take a job at almost any level of compensation. Less discussed, but possibly most important, is whether sufficient demand for goods and services exists throughout the world to produce at least modest growth and enough jobs in the major industrialized countries. Right now, various estimates for world real GDP growth this year are just under 3%, but deflation could bring nominal growth lower.

The decoupling idea has gotten off to a slow start. As a result of both the decline in the price of oil and the strength of the dollar, strategists have reduced their estimates for growth for the overall U.S. economy to something approaching 2%, and analysts have reduced their estimates of operating earnings for the Standard and Poor’s 500 to about $120 from $125. 2014 earnings were $118. Energy accounts for approximately 12% of the index weighting and only 6% of the estimated earnings, but oil and energy service company earnings estimates are being reduced by analysts everywhere. A downward adjustment in earnings expectations also seems warranted because the strength of the dollar is increasing costs and reducing translated profits for American companies operating abroad.

The fourth quarter real growth of 2014 was reported at 2.6%, disappointing most analysts. Inventory building accounted for .8%, and a good part of that was probably involuntary. Housing and capital spending were weak, and government spending and trade actually detracted from growth. Wage growth was also less than expected. The January employment report, however, provided some encouragement. Non-farm payrolls increased by 257,000, bringing the three-month increase to the highest in 17 years. Average hourly earnings were up 2.2% over the past year and, with more jobs being created, wage growth should improve. January showed an increase of .5%. The unemployment rate rose from 5.5% to 5.7% as the participation rate notched up, but an increase in the number of people entering the work force is a positive for the economy. Recent data on initial unemployment claims and job openings were both favorable.

Geopolitical conditions have fostered the mood of uncertainty. Russian-sponsored troops have moved aggressively in Ukraine, but now there is a fragile cease-fire that freezes the territorial lines and gives President Putin much of what he wants. While Kurdish troops took back an important city from ISIS, the threat of Islamic extremists remains serious in the region. A new king is in place in Saudi Arabia, creating some uncertainty on future oil production there. The March 24 deadline for an agreement with Iran to pull back from its nuclear weapons development program is approaching, but progress has been uneven. The country is resisting inspection of its facilities, and Congress is considering increasing sanctions. The European Central Bank has announced a program of quantitative easing, which begins this month, yet it is not clear if it will be enough to keep the continent out of a deflationary recession. Leaders from the new Greek government have compromised with their creditors on a four-month extension of the current aid program. The Syriza government had no choice, because capital flows out of the banks were threatening the financial system and the country faced the prospect of not being able to pay civil employees or pensions.

The mix of these positive and negative events has disheartened investors. Sentiment in the U.S. has moved from optimistic to neutral, on its way to settling into a state of caution that will provide a foundation for a better market later in the year if the fundamental framework turns positive, as I expect, in spite of the economic problems abroad. Equities perform better when investors are nervous, not euphoric. While the market has been volatile, it has risen 2.6% year-to-date. At current prices, the valuation of the S&P 500 is about 17 times based on trailing (12-month) earnings, a long way from the bubble points of past cycles of 25 to 30 times. There are, however, other measures of valuation that are more disturbing. Robert Shiller of Yale uses the cyclically adjusted price earnings ratio, which looks back a decade. It is now at 27.5, comparable to 1929 and 2000 levels. Gavekal Dragonomics looks at the aggregate stock market value compared to U.S. gross domestic product. At the current 155%, it is comparable to the 2007 level, but U.S. companies operate more globally than they did back then. I remain optimistic that 2015 will be a positive year for U.S. equities.

The second major concern is deflation. In the U.S., the GDP deflator was negative .1% at year-end. In Europe, the Consumer Price Index was down .6%. The deflation fear is likely to be supported by data for the next few months. Even in China, recent signs of deflation have brought on calls for monetary easing. In my view, this is largely because of the sharp decline in the price of oil, which, at its low, was down more than 50% over the past year. While this may help consumers, it is a major factor fostering the widespread talk of deflation. There are some signs, including the sharp drop in the rig count, that the price of oil may be bottoming, although the evidence is not conclusive. If that happens, the deflation argument could be neutralized. With storage capacity full, however, the possibility of a further oil price decline is feared. Excess production has to be sold somewhere.

The problem with deflation is that it encourages consumers to defer spending in anticipation of lower prices at a future date. With central banks around the world in a generally accommodating position, you would think inflation concerns would be on everyone’s mind. I understand that the data do not support the inflation view, but a modest increase in the price of oil could turn the deflation thesis around. The January U.S. employment report showing an increase in average hourly earnings adds to the case that deflation is not likely to occur in the U.S. this year. I have observed that inflation through the ages is largely influenced by house prices and wage rates, and both should be headed somewhat higher in 2015.

The situation in Europe is somewhat worse. The Ukraine conflict and the concern about Russian expansionism have made many consumers cautious. The terrorist attacks in France have darkened the mood there. While Greece is only a small part of the European Union, the possibility of default and withdrawal is a negative for the Continent. Also, Europe has an unemployment rate double that of the U.S., with youth unemployment twice the overall level, which has deflationary implications. While I do not think deflation will be a problem in the United States or China for long, it may continue in Europe. In general, I do not expect it to be a major factor in the world economy this year. Interest rates will remain low and money supply is expanding almost everywhere, which should reduce deflationary expectations.

The concept of demand is more elusive. You would expect the combination of monetary expansion coupled with population growth to increase the demand for goods and services. The middle class in poorer regions of the world, such as India and China, is expanding rapidly. The problem is that the supply of manufactured products is also increasing, and world income does not seem to be growing fast enough to absorb all these goods at the same or increasing prices. The issue of inequality may also be at play here. Those in the higher brackets spend a smaller proportion of their income on goods and services than those in the middle or lower quintiles. In 1980, the top 1% of United States earners accounted for about 8% of total income. In 2010, the figure was 19%.

The year 1980 was seminal for the supply/demand equation. Two factors came into prominence that endure to this day and will persist. The first is globalization beginning with the rise of China after the Cultural Revolution ended in 1976. Two years later, Deng Xiaoping’s implementation of reforms led to the country’s industrial expansion. Russia’s abandonment of the command economy followed a decade later, and India opened up as well. At first, we viewed these changes as providing three billion new customers for our products, but these countries became competitors as well, producing quality products at attractive prices.

The second factor was technology, which enabled products to be manufactured and services provided by fewer workers. Robots began to appear in factories, and many service workers found themselves displaced by technology. What’s more, the new jobs created in technology required a level of quantitative skill higher than that possessed by those who did not continue their education beyond high school. The combination of more efficient manufacturing; fewer jobs created by the new, Internet-related industries; and a growing world population helps explain our current slow wage improvement and job creation problems. It is unlikely that this condition can be turned around by monetary policy alone. Fiscal stimulus will be necessary. Economic growth in the future may be accompanied by meager job creation, and wages may increase only modestly. The supply of goods and services will continue to expand. The challenge is whether future buying power will be sufficient to produce jobs at reasonable wages for the growing population, but this is a longer-term problem.

Over the near term, the question is: How bad is the fundamental framework of the world economy? Some of the recent concern in the U.S. may be related to the 3.4% December decline in durable goods orders. Capital spending and housing were supposed to be two positives for the economy in 2015. Recent data from the National Association of Independent Businesses was encouraging with respect to small business hiring and capital expenditures. However, some of this will be offset by a slowdown in capital spending in the energy sector. As for housing, the increase in employment among the 16–34 age group, where most family formations occur, is a positive sign that has been reflected in recent data on housing starts, now running at an annual rate of over one million. Single-family starts were the fastest in seven years. Home prices were up and mortgage rates were down, factors which should sustain housing’s momentum. Family formations soared in the fourth quarter, boding well for housing and durable goods spending.

In his State of the Union address, President Obama said that the average family could save $750 on gasoline in 2015 compared with last year. December retail sales were down almost 1%, indicating that the expected boost in retail sales has yet to appear. Perhaps consumers are catching up on unpaid bills and other debts, but at some point consumer spending, the single largest component of the U.S. economy, should improve. Based on past oil price declines, consumer spending only improves after a lag, and right now the focus is more on services or “experiences” than goods. The rise in the University of Michigan Confidence Index indicates that consumers are feeling more positive about the outlook and may be willing to step up their spending.

Also, the news out of Europe isn’t all bad. Spanish GDP for the recent quarter was reported at 2.8% and retail sales were improving. French consumer spending also increased. Economic expectations were improving in Germany while exports were strong as a result of the decline in the euro, and consumer confidence was rising in Italy. All of this has been happening prior to the start of the European Central Bank’s monetary stimulus program. China may be slowing, but it is still growing faster than most emerging markets, and it is the world’s second largest economy. Their debt to GDP ratio enables them to implement some further stimulus. Better economic data are even coming out of Japan, where exports are up sharply. There may be some evidence of recoupling, rather than decoupling, in that Europe and Japan are showing signs of strength.

I also believe the geopolitical situation will become more stable during the year. I think U.S. GDP will increase close to 3%, and, taking into account that the valuation framework is favorable, the S&P 500 will have another positive year. I do not believe deflation is a serious near-term problem and concern about it will diminish over the coming months. My big worry is whether supply will overwhelm demand in the years ahead. Right now, I’m not too concerned about decoupling and deflation. Assessing all of this economic data, I cannot help but wonder whether the world economic outlook is as bad as the consensus view.


(c) Blackstone


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