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Economic Insights

The recent surge is not likely to continue, but obstacles to growth are even greater elsewhere.

 

In Brief

  • The U.S. economy grew by an annualized rate of 4.6% in the second quarter of 2014, according to the Bureau of Economic Analysis, marking the third quarter in the last four in which real economic growth exceeded 3.5%.
  • It appears unlikely, however, that the recovery will continue at this pace. Various structural factors and other longer-term impediments stand in the way of a stronger expansion.
  • But it’s also unlikely that the U.S. economy is in a period of “secular stagnation,” as some economists have suggested. Secular stagnation suggests the economy’s performance would be impervious to policy improvements. In reality, although there are secular aspects to the current sluggishness, certain structural reforms would probably produce higher growth.
  • The European Central Bank recently cut its benchmark interest rate and has begun to embark on a policy of quantitative easing. But monetary policy may have reached its limit, and may have already created other problems, including a credit bubble in emerging markets.

 

The U.S. economy expanded by an annualized rate of 4.6% in the second quarter of 2014, rebounding sharply from the first quarter’s 2.1% contraction. In fact, gross domestic product (GDP) has risen by more than 3.5% annualized in three of the last four quarters. But a number of factors suggest the economy will soon return to its muddle-through pace of the past several years.

Some economists have even raised the possibility of “secular stagnation,” given that the problem of tepid growth, even in a loose-money environment, predates the financial crisis of 2008–09. Nevertheless, for the time being, the pace of growth appears practically torrid when compared with rest of the developed world. The eurozone continues to slump, and now faces the possibility of deflation. The European Central Bank (ECB) recently cut its benchmark interest rate and will soon begin a type of quantitative easing, though it faces some resistance. These policies do not come without a price, however, and the Bank for International Settlements (BIS) has indicated that monetary policy in the developed world is too loose, resulting in asset bubbles and excessive levels of debt in emerging markets.

Tackling these and other issues are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; and Harold Sharon, International Strategist.

Q. GDP has grown by 3.5% or more in three of the last four quarters, starting in third quarter 2013. Is the recovery finally kicking into high gear?

Ezrati: I’m skeptical that growth is going to continue at this level. What we’ve seen recently are surges that are not sustainable. We saw a surge in inventories in the third quarter of 2013, followed by a drop in the fourth. Housing was also weak in the fourth quarter, but the weakness in inventories and housing were more than covered by a surge in consumer spending. In the first quarter of this year, growth was -2.1%, in part due to the weather, but also because consumers pulled back after outspending their income growth in the previous quarter.

In the second quarter of 2014, we saw a surge in housing, manufacturing orders, and construction activity, but these were all rebounds from the weather-related slowdowns in the first quarter. What we’ve seen so far in the third quarter is a response to these second-quarter surges—a decline in manufacturing orders and a decline in construction spending. So, I’m skeptical that GDP can continue at the 4.6% rate of the second quarter. 

Even with the strong performance recently, GDP growth has averaged only 2.6% over the past four quarters.

Brown: It’s hard to believe that we could be growing 3–4% a year, because job growth is only around 200,000–215,000 per month [according to the Bureau of Labor Statistics] and wage growth is barely keeping up with inflation. Also, in the second quarter of 2014, people began purchasing health insurance under the Affordable Care Act, and that could spill over into the third quarter as well. Although this contributed to GDP in the second quarter and will also contribute in the third quarter, it’s essentially a one-time increase; it won’t continue much after that. 

So, that’s another reason this pace of growth is probably unsustainable.

Ezrati: If consumers start outspending their incomes on a regular basis, which they did in the fourth quarter of 2013, this surge will come to an end very quickly, because they’ll become stretched and will have to pull back. So, unless businesses start hiring and start investing the cash on their balance sheets, this won’t continue. So, I don’t think we’re off to the races yet.

Q. If the recent surge in growth is not sustainable, is it possible that the U.S. economy has entered a period of “secular stagnation,” as some economists [such as Larry Summers, former director of the White House U.S. National Economic Council under President Obama; Minneapolis Fed president Narayana Kocherlakota; and Fed vice chairman Stanley Fischer] have suggested?

Ezrati: There are demographic reasons for the slow growth of the economy, but there are cyclical things going on as well. The recession was inordinately deep, for reasons we’ve discussed, and it’s left a legacy of caution that weighs on the growth rate. But that won’t last forever. So, Summers might be right about the demographics and other structural reasons for the economic sluggishness, but that doesn’t mean that the growth rate needs to be 2.0% or less forever.

Brown: I think there are structural aspects to the economy’s sluggishness. baby boomers are retiring, downsizing, and spending less. Also, the millennials are not that interested in household formation, and they’re more interested in renting than owning. These trends are present in other developed economies as well. That means that unlike in the past when we experienced a cyclical downturn, other economies won’t be able to help pull us out of it.

Ezrati: The mismatch in skills between what employers need and what the labor force has to offer may also be contributing to the downturn by keeping the unemployment rate high. And that won’t be solved overnight; as the economy continues to become more knowledge-based, workers who lack those skills are having a harder time finding work.

There are two other factors hindering this economy. One is the legacy of the Great Recession. Business spending and hiring don’t occur unless management becomes more aggressive, but the experience of 2008–09 has scarred them. I think the amount of cash sitting on corporate balance sheets is evidence of that. Because of that experience, and because of the difficulty they may have had obtaining financing at that time, firms feel they must be self-financing.

The other factor is the regulatory environment. The Affordable Care Act and the Dodd-Frank financial reform legislation created a lot of uncertainty. Congress is not passing much legislation now, but what they have passed remains ambiguous. The requirements of the Affordable Care Act, for example, are still unclear, and I don’t see that changing anytime soon.

On the bright side, increased M&A [mergers and acquisitions] activity is one sign of life in the economy. It means that businesses are again willing to take risks and is evidence of what [British economist John Maynard] Keynes called “animal spirits.”

Brown: It is positive in that sense, but M&As contribute to the unemployment problem because they usually result in layoffs. They are also a reaction to the limited opportunities to invest in organic growth. Because the economy is growing so slowly, companies can’t justify investing in their own new growth, so instead they buy existing growth by acquiring a company. But that often means eliminating employees that are duplicative, such as a sales force, for example.

Q. The U.S. Federal Reserve is ending its quantitative-easing program, and expects to raise the fed funds rate by mid-2015. In Europe, the ECB is facing resistance to its quantitative-easing program. Can the global economy grow without extraordinarily accommodative monetary policy?  

Brown: Monetary policy has pretty much done all it can globally. Europe is taking a more targeted approach with its purchase of asset-backed securities, but in the grand scheme of things, that program won’t be enough to get those economies going. What is necessary is structural reforms that will make them more competitive.

Ezrati: Fiscal stimulus is out of the question. If the eurozone were to give up on its budget constraints, it could run out of room to borrow. With France, for example, there’s so much debt out there on the market already, that if France showed any sign of losing its commitment to fiscal austerity, the investment community would walk away from French debt.

Sharon: This does point out the pressure for government authorities to truly focus on growth-enhancing programs and policies. Policies on the fiscal side have just disappointed massively around the world. We’ve seen very few government privatizations or rollbacks of government interference in large economies. I would hope that as monetary policy stimulus fades, we’ll see more on the fiscal side everywhere.

Brown: Can the global economy grow without easy money? We’re going to find out. It’s not growing very rapidly even with easy money. The United States has been growing at around 2–2.6% in real terms, even with easy money, so the question becomes, what will happen when the Fed begins to raise rates? If the Fed does that aggressively, you would think it would have some impact on growth.

But the Fed might not be as aggressive as its interest-rate projections imply. The Fed suggests that by the end of next year, the fed funds rate will be between 1.25% and 1.5%. What that implies is that it will make five or six consecutive quarter-point moves, starting in April 2015. I don’t think anybody is expecting a rate hike that soon.  

If the market is looking out that far, which I’m not sure is the case, it would be easy to come to the conclusion that the Fed cannot be as aggressive as it is suggesting. An aggressive stance by the Fed would hurt housing. So far, the housing recovery has been supported mostly by investors taking advantage of low prices and foreclosures. Prices have risen and foreclosures have slowed, so now would be the time that low interest rates would help homebuyers, those that want to buy the home to live in it. But now interest rates are probably going to rise. So, will rising rates affect the housing market? I think so.

Also, at its meeting in June 2014, the Fed said it expected 3.1% growth in 2015. At this last meeting [in September 2014], it lowered its expectation to 2.8%. Also, in June, the midpoint of the Fed’s interest rate projections for year-end 2015 was 1.13%. But at the September meeting, the midpoint was 1.38%. That means that in a slower-growth environment, the Fed supposedly will be more aggressive in raising rates.

So, I think their interest-rate projections are optimistic. The bottom line is that I don’t think growth will be strong enough to allow the Fed to be so aggressive. That doesn’t directly answer your question about whether the economy can grow without easy money, but I think the Fed will handle these rate increases delicately. But I don’t think the rest of the world is ready to abandon easy money policies.

Q. The Bank for International Settlements [BIS] said in its annual report that monetary policy around the world is too loose, and that this is leading to bubbles in capital markets. Has the market priced in interest rate increases? Is the stock market, or parts of it, such as technology, in a bubble? Is the bond market?

Ezrati: As far as the U.S. stock market goes, it’s near new highs, but price-to-earnings [P/E] multiples are about where they’ve been over the past 35 years. Relative to cash and relative to bonds, the market looks cheap. So I don’t see where the BIS is getting the idea that the market is irrational, euphoric, or disconnected from fundamentals.

Brown: As for bonds, I think we’re far from a bubble in most categories, with the exception of Treasuries. Treasury securities really are priced too high. They’re artificially low in yields because of the Fed’s zero-interest rate policy and because of quantitative easing. So relative to inflation and relative to our economic growth, they are too low.

But yield spreads on investment-grade bonds relative to Treasuries are wider than average. In the high-yield market, spreads are narrower than average, but at 500 basis points [bps] [as of September 30, 2014; all yield spread data is from Bloomberg, unless otherwise noted], they are a far cry from the previous low, which was 270 bps. So, are bonds in a bubble? No. The only category that appears to be overpriced is Treasuries, and the Fed is in the process of letting the air out of that market by ending its quantitative-easing program.

As for stocks, Strategas Research has pointed out that profit margins are continuing to expand. This means that even in our current slow-growth economy, the market could produce a reasonable return. If nominal GDP grows by about 4%, if overseas earnings grow, and if companies continue to buy back shares, the market could produce a return in the mid to high single digits. That’s even if P/E multiples don’t rise. So even if we get that kind of return over the next 12 months, it would be hard to characterize a market like this—which continues to rise, but only enough to keep up with increased earnings—as being in a bubble.

By the way, as Milton has pointed out in the past, corporate profit margins have been high because of operating leverage. In the wake of the financial crisis, businesses invested a lot in equipment and machinery, so they now have higher fixed costs than in the past. That means that once sales are high enough to cover those fixed costs, any additional sales that occur primarily have to cover variable costs, so the bulk of those revenues go to the bottom line.

As for the BIS, it could be that its statements are being driven by an agenda. The BIS is an organization of central bankers, so they may be trying to send a message that fiscal policy needs to change and structural reforms are needed. In other words, monetary policy cannot solve the economic problems in developed markets. 

Ezrati: The other thing to note is that the economy is still operating at less than 80% capacity, so that suggests there’s room for even more operating leverage.

Brown: The bond market in Europe, on the other hand, is another story. I think that’s pretty dangerous, given the possibility of negative economic growth. Yields in the high-yield market are almost 100 bps lower than they are here. That’s where there is really some risk. An economic slowdown could result in a lot of bankruptcies and a significant loss of principal.

Ezrati: Europe faces the possibility of deflation, so the low nominal yields may be sustainable, but in a deflationary economy the outstanding debt becomes larger and larger relative to the rest of the economy, so it becomes a greater burden for countries that are already overburdened with debt.

The strategy that the ECB has been using to combat deflation is coming unwrapped. Although the bank has lowered interest rates, it has, in effect, raised real [inflation-adjusted] interest rates. Two years ago, the benchmark rate was 1.5% and inflation was 2.5%, so the real rate was -1% [1.5%-2.5%=-1.0%].  Today, the benchmark interest rate is 0.15% and inflation is .30%, which means that the real rate is -0.15%. That means that the ECB has raised the real interest rate from -1.0% to -0.15%, or 85 bps [-1.00-(-0.15) =-0.85] over the past two years.

Brown: What is needed is some kind of policy to provoke growth or labor market reform to make the eurozone more competitive internationally. But there is no effort underway to make the necessary reforms, so the prospects of the eurozone turning around anytime soon are pretty minimal.

Ezrati: Italy was making an effort a few years ago under then-Prime Minister Mario Monti, and today Prime Minister Matteo Renzi is talking about reform, but nothing is happening. In France, it seems that whatever concessions the government gives with one hand, it takes away with the other. So it might provide relief for corporations by reducing employment-related taxes, but make that up by increasing the value-added tax. So, in effect, there’s no relief in taxes, just a shift.

The other thing they do in Europe is subsidize inefficient factories in order to keep people working. According to The Wall Street Journal, there’s a refinery in Sicily that has lost €10 billion over the last five years. Demand for refined petroleum products is down 30% since 2006, but the company is not allowed to close the refinery. The article also mentioned that Italy also recently gave tax breaks to Electrolux, the appliance maker, to keep factories open that Electrolux wants to close. Last year, Bloomberg reported that if auto production capacity in Europe matched to demand, 18 auto plants would be closed. That’s one reason Europe has deflation—because they’ve got this glut of products.

Q. Easy money has led to troubling debt levels, especially in emerging markets [EM], according to the BIS, and these markets are much bigger today than when the Asian crisis hit in the late 1990s. China, in particular, has had a boom in consumer lending for the past five years. How much of a threat is EM debt?

Ezrati: In the 1990s, one of the things that hurt emerging markets was that all their debt was in U.S. dollars. So, when their currencies depreciated, they couldn’t repay it. Today, much of the sovereign debt, at least, is in local currencies.

Brown: Corporate debt is still largely in dollars, however. In places like Brazil, which was growing very rapidly a few years ago, a lot of companies issued debt to finance huge expansions to expand their capacity and capitalize on the growth. But today, the Brazilian economy has slowed and the global economy has slowed. And, unfortunately, this debt is dollar-denominated, while their revenues are largely in Brazil’s currency, the real. At the time, issuing debt in dollars made sense because money could be raised quickly and at low rates.

But now, with the dollar strengthening, the real is worth less and less, making debt payments for these companies more and more difficult. So there could be a rise in corporate defaults as a result.

Ezrati: They’re in the same boat that many Asian countries were in in the late 1990s.

Brown: The situation is China is different, but still pretty alarming. The property market accounts for between 20-30% of GDP, according to Bloomberg data, and sales and values have been falling. The Wall Street Journal reported that housing sales dropped nearly 11% in the first eight months of 2014, and prices fell more than 3% between April and September. The decline in prices may not sound like much, but the Journal said it’s about the same decline that occurred over a 10-month period in 2011-12. So, the decline this time has been more rapid.

There’s not as much leverage in the housing market as we have here. Homebuyers will often make down payments of 30–50%, but this drop in home values means that consumers can’t act with the same level of confidence that they have in the past.

Foreign direct investment has also declined for the first time in years. Manufacturing costs are higher now even relative to the United States. So, they don’t have the same cost advantage they had years ago. So, China may not achieve the 7.5% growth that they have targeted.

Sharon: There has been a large build-up of debt in many emerging economies since the financial crisis.  In essence, as exports to the developed world slowed, many emerging economies, and China in particular, bridged the growth gap by substituting a credit-fueled economy for their export-led economies. As Milton said, at least this time the debt is mostly local, and with companies and individuals, not governments. But as we’ve seen in the past, these emerging market credit cycles always produced a bad-debt cycle at some point.

China’s government has the wherewithal to take on the bad debt if necessary, but other emerging markets, such as South Africa, Indonesia, or Turkey, don’t have that luxury. We’ve already seen a few spectacular EM company debt blowups, and I suspect we’ll see more, especially in Eastern Europe, given the sanctions on Russia.

Q. What are the investment implications of this slow-growth, loose money environment?  

Brown: I think U.S. equities still have a reasonable chance to produce an 8–10% return over the next 12 months. And that probably will exceed any returns in any segment of the fixed-income market if the Fed is able to begin adjusting rates higher. Even high yield may not give you that kind of a return, because the coupon is around 625 bps [as of September 30, 2014], and with interest rates likely to rise, there will be some loss of principal.

Ezrati: On the equity side, among developed markets, I think the United States is preferable on a risk-adjusted basis, even though valuations are lower in Europe and Japan. On a risk-adjusted basis, I would still favor the United States because Japan has structural economic problems that they still have not dealt with. In Europe, they have the economic sluggishness that we’ve discussed here, and they’re not dealing with it. And I would add that Europe is closer to Ukraine and Japan is closer to North Korea.

Brown: So the threat of geopolitical risk is greater in those markets. But there are likely to be large exporting companies that are likely to get most of their revenues from outside Europe, and there may be opportunities among those companies.

Ezrati: From an asset allocation perspective, the U.S. stock market is more attractive, but from a stock-picking perspective, the more fertile fields may be in Europe and Japan.

Sharon: I agree with my colleagues, but I think the time to reenter the European markets may be early next year, when the ECB has given an “all-clear” signal as the new bank regulator in Europe. The nagging issue of European bank solvency will be, for all intents and purposes, closed; it won’t be viewed as a potentially systemic threat. By early next year, we’ll know what the level of liquidity and capital is in the system, and that will force the banks to get to the ECB’s desired level. 

The optimistic scenario would be that at the same time that we see more policies aimed at boosting economic growth and employment, and reducing austerity, that the depressing signals we now see in Europe will turn for the better. It will not be rapid, but the decline in the current market and in the currency could provide a nice entry point later for a potentially less bad 2015. That would surprise markets and make for reasonably good equity returns.

Q. Thank you, gentlemen.

 

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