Equity markets continued a mildly upward trajectory over the first quarter. Yet we face headwinds that are in some ways stronger than last year. On the whole, earnings growth rates are slowing substantially. The U.S. is showing signs of moderation in the face of weather impacts and an unofficial strike at west coast ports. U.S. dollar strength is making goods produced here at home less competitive on world mar- kets, which is weighing on export activity. And declining oil prices haven’t yet produced the wave of consumer spending expected. So far the data says we are not spending all of our income growth and en- ergy savings, and are paying down revolving and mortgage debt instead. Pragmatic behavior, to be sure, but less helpful in growing an economy driven 70% by consumption. Poor weather and distribution bot- tlenecks are behind us and we expect the oil price weakness and U.S. dollar strength trends to be short lived. In addition, we expect a bounce back in the second quarter led by the consumer. At 15.5x forecast 2016 earnings, the market is reasonably priced, and we think it still has room to grow.
More broadly, economies world-wide look a bit different than just a quarter ago. In contrast to what is happening here, forecasts for Japan are moving higher as quantitative easing continues. The Euro area too finally jumped into the monetary easing realm with a plan to purchase over $60B of securities per month through September 2016. As a result, the euro has declined in value, which has boosted exports, and manufacturing activity has picked up. And China, under its own monetary easing programs, is trying to manage the slowest growth rates in nearly 15 years.
Following the significant declines in 2014, oil prices have been range-bound this quarter, sharpening de- bate about where they go next. After the OPEC decision in late 2014 to maintain production levels, ob- servers expected US production to be the lever that would bring supply down to better balance demand. Accordingly, capital expenditure plans were cut and reported rig counts declined by 50% from their peak last October. Due to time lags between well development and oil production, daily volume will continue increasing until next quarter, further muddling the already murky task of divining the direction of oil prices. Excess supply has pushed storage capacity worldwide to limits not seen in years, which is also de- pressing prices. In a twist, gasoline prices are well off their bottoms as refiners have presented a production bottleneck resulting from shutdowns due to scheduled maintenance and their own union strikes. Political actions are still impactful, exemplified by the jump in prices when Saudi Arabia escalated the conflict in Yemen. There is also the possibility that a successful nuclear negotiation with Iran may lead to relaxed sanctions and an increase in their own oil exports by up to one million barrels per day on top of existing excess supply. Energy and oil prices will remain in the news, but despite the conflicting signals, we think oil has likely found its bottom.
As energy prices declined, we followed a debate about the impact on U.S. GDP as the energy sector re- aligned itself with the new market level. For all the ink spilled over the last 9 months since prices last peaked, two misconceptions surrounding the decline in energy prices are worth clarifying; oil employment and capex are too small to matter. First, we note estimates that oil and gas extraction employs approximately 1m people, or less than 1% of the 150m+ labor force. These include oil and gas extraction and support, pipeline construction, mining field machinery manufacture and petroleum refining. Due to the capital intensive nature of these businesses, only about 150,000 new jobs have been created in these sectors over the past 3 years. Compared to the more than 7.5m jobs created over that same time span, new oil jobs have been a very small part. Secondly, investment in oil and gas structures and equipment have nearly doubled in this expansion, but the sector only represents 7% of total business investment. Important levels for jobs and investment to be sure, but hardly critical to the whole.
One danger of following the markets on a daily basis as we do can lead to a myopic, or short-sighted, view of the economy. It is very easy and tempting to fall sway to the latest data release and try to divine what that means for the future direction of an economy or market. To counter this tendency, it is important to step back, sometimes way back, to see what the longer-term data is showing us about where we are heading. The uneven characteristics of the current growth cycle make this exercise even more important.
Economists have an inclination to look at previous business cycles to help predict the speed and lifespan of current cycles. The 2008-09 recession differs from earlier cycles due to the significant influence from excessive leverage. By 2009, consumers felt it was necessary to return finances to a sound footing before resuming their previous focus on spending. Associated job losses in the recession contributed to a decline in demand for both products and loans, leading to weak growth and a tepid response to low borrowing rates. The upshot is that the current recovery has hit certain milestones much later than in earlier cycles. For perspective, the current growth cycle is 69 months old, having started in June, 2009, which is far longer than the average of 39 months, and double the median of 30
months. While that may cause one to question how much further we can go, there are two factors to consider that suggest further growth lies ahead.
One, this expansion has largely taken place without the usual level of contribution from housing, as job losses and constrained budgets severely limited household formation. After a typical recession and the associated job losses, household formation usually plays catch-up for about three years, but this cycle required five, as formation has only recently returned to pre-recession levels. Taking away this headwind should contribute to more housing activity than we have seen in a number of years. Anecdotally, new home sales in February reached levels not seen since mid-2008.
Two, households have been working hard to reduce debt levels since the recession which, in tandem with modest income growth has earned them breathing room to more adequately service their financial obligations (see accompanying chart). And following an accelerating trend in job growth that picked up materially in 2014, households are working more, their stock portfolios are up, leverage has been reduced, and they are able to spend when ready. These income and wealth gains and resulting consumer purchases are signs of greater confidence in both present situations and prospects for future employment and income.
Although it feels like we have been debating for years when the Federal Reserve would be raising rates, it is only now that the Federal Open Market Committee has begun broaching the topic in their public communications. For years, under multiple quantitative easing programs, fixed income investors have been subject to an artificially suppressed rates environment meant to encourage risk taking. By setting the stage to move monetary policy back towards some definition of ‘normal’, we are finally moving into a different era where investment fundamentals matter more than before. But moving into this next phase will entail a great deal of uncertainty. Six years of unconventional policy has left the FOMC facing the grim challenge of how to get to ‘normal’ using a combination of new tools that are untested in the real world, and older tools whose usefulness is in serious doubt. We will continue to minimize poorly compensated risks in navigating these markets by focusing on high quality, liquid issues, with shorter maturities in our fixed income portfolio.
Our recovery has put to the test many long-held economic theories, the latest being the links between job, wage and inflation growth. The problem now is that we have seen increasingly strong jobs growth over the last 12-18 months, but expected wage growth and accompanying inflation is still weak. Despite worldwide liquidity nearly doubling since 2008 as the result of monetary policies, goods prices are weak because suppliers used that liquidity to expand capacity, but the expected demand growth hasn’t shown up yet. Perversely, every central bank, except the Federal Reserve at present, believes the solution is to throw even more money at the problem. It is for this reason that so many FOMC voters are comfortable letting the unemployment rate drift lower and lower without action on rates, until they see the wage growth that typically leads to increased demand and greater spending activity.
Nearly 3.1 million jobs were created in the last twelve months, a rolling total we have recorded for the last three quarters. Unemployment is currently 5.5%, a rate historically associated with full employment and employment growth is expected to continue for the foreseeable future. Jobs growth is the fundamental foundation upon which an economy can grow and inflation pressures can materialize, and the FOMC will see the wage growth and accompanying inflation pressures it seeks before long. We expect them to begin liftoff by September, and will stress their reliance on the data before moving again.
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