In an environment of low rates and heightened uncertainty, the U.S. has experienced sub-par growth during this economic cycle relative to past expansions. But compared to the rest of the world, the U.S. has been a strong performer. And even with only moderate growth, the U.S. economy has experienced healthy job creation – 11 million jobs since the bottom of the recession, 3 million created last year, the highest since 1999, and 2.5 million this year. What we didn’t get in strength in this recovery, we are getting in longevity. We are already above average in terms of the length of this recovery and we think it is likely to continue as the economy still has a lot of runway due to the better financial health of both consumers and businesses.
Consumers, the Housing Market and Business
In fact, we think the financial crisis likely changed the behavior of consumers. Today we see more cautious consumers spending less than they make which clearly contributes to the muted recovery. This is a good thing in the long run. They have more capacity to spend in the future. Also supporting consumers’ capacity to spend in the future is much improved personal balance sheets. Household net worth—the combined value of housing and investments—is well above pre-crisis levels. Remember the consumer drives 70% of GDP.
This “smarter,” more cautious consumer is also using less debt than in the past. But the rapid growth in student loans has been a concern for a while. Seventeen percent of student loans are more than 360 days delinquent, and almost 2 million borrowers have more than $100,000 in student loans.
The slow but steady improvement in the housing market – both home sales and home prices have moved higher – is a positive sign. Home ownership rates are now back to a long-term sustainable level that, along with rising rents, should bode well for further improvement in the housing market.
Like the more disciplined and cautious consumer, we have seen similar behavior by U.S. businesses. Although profits have been very strong, there has been a more muted and delayed response to capital spending. This too bodes well for continued moderate growth in the U.S. economy. Also increasing the likelihood that this moderate growth expansion will continue is the drop in energy prices which clearly benefits both consumers and most businesses.
Global Uncertainty
While we see a steady, moderate growth expansion continuing in the US, things look weaker and less certain in other parts of the world. The Eurozone has struggled for growth and experienced a double-dip recession post financial crisis as fiscal and monetary policy coordination has proved difficult. Although a full blown crisis in Greece was averted for now, the heightened uncertainty acts as another headwind to Eurozone growth as consumers and businesses exhibit more cautious behavior.
Japan is also struggling for growth in this post-crisis environment as it has for the last 25 years. Furthermore, most of the high flying emerging market countries that had led the global economy out of the Great Recession are now losing altitude. The slowdown in emerging market economies has had a significant impact on global growth, shifting from a tailwind to a headwind. And China, the second largest economy in the world, is heading in a different direction from the US and has a disproportionate impact on what’s going on in emerging market countries.
China
Because of China’s sheer size and global impact, it warrants a closer look. China is now 13% of global GDP, up from just 3.5% in 2000. More importantly, their contribution to global growth has been 30% in this post-crisis period. China has dominated global demand for commodities, and changes in that demand have a huge impact on commodity prices.
While the slowdown in China is having a broad, global impact, just how much is China slowing? China’s actual growth is likely less than the 7% the Communist Party has reported. To get a better handle on Chinese growth, we follow the “Premier Li” Index. Premier Li is the second in command of the Communist Party and has lead responsibility for economic policy in China. He suggested several key indicators that measure more objectively the underlying strength of the economy. We believe the index – which tracks bank loan demand, rail freight and electricity consumption – better tracks the underlying strength of the national economy and suggests that real growth is much closer to 1.5 or 2%.
The decline in Chinese equities is likely damaging consumer and investor confidence in Chinese policy makers’ ability to “fix-it.” The rapid rise in margin debt is one of the many missteps of Chinese policy makers. However, China has ample dry powder to stem the decline and reaccelerate growth in their economy. They can cut rates or significantly increase funds available for lending by lowering reserve requirements or by direct liquidity injections. And as we just saw a couple weeks ago, they can also devalue their currency.
Federal Reserve
This slowdown outside the U.S. led by China and by heightened global uncertainty has made the Fed’s decision to begin raising rates much more difficult. Since the financial crisis, in addition to its traditional dual mandate of price stability and full employment, the Fed is now focused on a third objective of broad financial stability.
U.S. inflation measures remain benign. Headline CPI has been well below the Fed’s 2% target for some time, and wage inflation measured by average hourly earnings has been well behaved. Yet there is limited slack in the labor markets based on traditional measures. The unemployment rate at 5.1% would say we are at “full employment” and the Fed should move, but benign wages say that there is potentially more slack in the labor force than the official numbers measure. The significant decline in the participation rate clouds whether we are truly at “full” employment.
To better understand what’s going on with wages, it’s helpful to further dissect the data. When you break-up the labor force into various wage categories, you find that only the highest earners have had positive real wage growth over the past 5 years, while everyone else has lost ground to inflation. The more recent gains for low-wage earners is potentially an early sign that wage pressure may be building. The fact that 18 states raised minimum wages last year was likely a contributor to upward wage pressure in this category. This bottom-up wage pressure could be a turning point to overall wage gains, though we expect any increase in wages to be modest.
In our view, the uncertainty caused by speculating on when the Fed will raise rates is almost worse that the move itself. While only 10-15% expect the Fed to act soon, we don’t underestimate advisors to Janet Yellen like Stanley Fischer who may say, “We just gotta get it done.” We think the Fed needs to forecast where the U.S. economy will be in terms of full employment and inflation a year or two down the road given the long and variable lags of the impact of their policy changes. We think they have been too optimistic in terms of the expected growth of the economy.
In addition to determining the timing of their first move, the Fed must also consider what tools it will use. They will need new tools to navigate their exit from their extraordinary policy response over the last 7 years. The Fed’s exit out of these uncharted waters will require new tools as the Fed has never before needed to raise rates at a time when it had over $3 trillion of excess reserves in the banking system due to their large scale bond purchases, also known as quantitative easing (QE). To lift rates off zero the Fed will need to use two new tools: the overnight reverse repo (ORR) and interest on excess reserves (IOER). They will for the first time have a policy range with the floor being set by an overnight reverse repo rate and the ceiling set by the interest rate on excess reserves. In fact, the Fed may want to make a move off zero just to make sure this new “plumbing” works!
Investing Outlook
This environment of heightened uncertainty is likely to continue with a presidential election around the corner. We warned last year that volatility was likely to move higher and it began to ramp up late last year. Recent volatility in the markets reflect the uncertainty surrounding the global slowdown of growth led by China and the timing of the Fed’s first move.
U.S. Treasuries are still attractive to the rest of the world. Global investors are seeking dollar denominated yields. We have 15% in Treasuries versus 30% for the index. We have mostly eliminated shorter maturities which we believe are most vulnerable to rate increases.
Modest changes in the yield curve year-to-date mask the increase in volatility we have seen. Not only has there been volatility in interest rates, but yield spreads have also widened in this environment of heightened uncertainty. The majority of spread widening has been in the corporate sector, given its additional headwind of record new supply.
We are slightly overweight to credit – though we are very well diversified and seek to manage risk carefully. Corporate credit fundamentals still look solid. Revenues, profits, free cash flow and liquidity all look very strong, though leverage has started to creep up. But many of the companies increasing leverage are higher rated companies that have the “room” to take on more debt. Overall, investment grade companies’ ability to service their debt remains very good. And though M&A activity has picked up this year, it’s been more bondholder friendly than in the past. Many more of these deals are being done with a combination of cash and stock as opposed to heavily weighted to debt financing, which, as bondholders, we find very encouraging.
One other area of concern that we continue to monitor very closely is liquidity in the bond market. The size of the corporate market versus the shrinking amount of dealer inventories remind us that Wall Street doesn’t play the role they once did to provide liquidity. However, being a disciplined supplier of liquidity can sometimes be our advantage.
Conclusion
As so many have reached for yield in the current market cycle, it reminds us again of the important role of high quality bonds in an overall investment strategy.
Consistency is crucial for core fixed income investors and is now more important than ever in an environment of low rates and heightened uncertainty. While we are a bottom-up manager, we do need a top down global macro view to inform our sector allocation and security selection. We calibrate the risk environment and evaluate how much we need to get paid for every unit of risk.
