March employment data on Friday confirmed the weakening domestic economy that other data have been indicating and which we have been discussing for several months.
Not only was the March increase in employment a disappointing 126,000 net new jobs, the increase of the prior two months was reduced by 69,000 jobs. Meanwhile, we recently predicted that a combination of a weakening U.S. economy coupled with a strengthening European economy would result in a counter-trend rally in the euro vs. the dollar. Furthermore, we predicted that domestic economic growth would reaccelerate as we moved through April and resume its 2.5% to 3.0% annual rate of gain for the rest of this year. This countertrend rally should end by June, when the dollar should start to strengthen again.
This period can be thought of as a refreshing pause that will lead to better days ahead.
I published two other blogs last week, "The Three Bears Market" and "Self Fulfilled Prophesies." The first one pointed out that the stock market was confused and did not know whether it wanted acceleration in growth (too hot), stagnation in growth (too cold) or moderate growth (just right). It mentioned that fears of Fed tightening earlier in the year due to too much growth hit both the bond and stock markets. Recently, fears of too much economic weakness hit the stock market but boosted the bond market. I discussed that the first quarter would be the trough for the year and that the economy, along with corporate profits, would pick up steam. Finally, I concluded that the stock market is more leveraged to changes in interest rates than a small change in earnings, so despite the lower than expected first quarter profits, much lower interest rates this year would lead to rising stock prices. But not all stocks are equal.
The other piece pointed out that if you believe something hard enough, it will come true. Such is happening with Greece remaining in the Eurozone, at least for now; growth accelerating in the Eurozone; and economic problems in Japan and China. Also, a nuclear deal with Iran will be reached at any cost, even though it may not be good longer term for world peace and, finally problems in the Middle East won't escalate to the point of jeopardizing oil supplies. I concluded that investors shouldn’t let short-term events override long-term investing.
Let's look at what is happening in each region and the implications for asset allocation and investing:
1. The March employment data confirmed the U.S economy slowed tremendously during the first quarter, even after disappointing fourth quarter growth. The reasons include an unusually harsh winter impacting consumer spending and industrial production to a strong dollar impacting exports; the west coast dock strike; a sharp decline in energy prices both positively and, most of all, negatively impacting many sectors of the economy; and finally and most importantly, a conservative bias pervasive among consumers and businesses alike.
Consumers have substantially increased their saving rate, pocketing a major portion of what they’re saving in energy costs. Meanwhile, businesses large and small don't know if this slowdown has a larger meaning, and therefore, are maintaining tight controls over all costs and spending. Governments at all levels are still being forced to further reduce their deficits and Washington D.C. is gridlocked, unable to make regulatory, spending and tax changes needed to stimulate the economy for the near and longer term.
The U.S economy will resume faster growth in the spring, boosted by consumer spending, milder weather and some growth overseas, but will stay constrained over the longer term. The implications for investing are obvious: Financial assets should be favored over hard assets. This is a major theme for investors to follow. Economic cycles will continue, but there will be lower highs and higher lows in economic activity.
2. While Greece was the focus of all investors last week, it should be understood that Greece's GDP is less than 3 percent of the European economy. While the Greek government made a laundry list of proposals to the ECB to get more funding and to remain in the euro, there were no real changes in areas that break the budget over time, like pension reform and other needed regulatory changes. Remember that this new government was elected to reverse the policies of the former administration that was abiding by its deal with the ECB to get funding. But for now, Greece was put on the back burner until June, when the ECB can see whether the substantive changes proposed actually are working. I doubt it.
The key economic data points for the Eurozone have been boosted by a positive change in both consumer and business confidence. While prices continued to fall, the rate of change was less than in prior periods and fears of deflation dissipated. Employment data was favorable throughout most of Europe and consumer demand appears to be picking up steam, benefitting from lower energy costs, higher disposable income and higher wages. Exports clearly have benefitted by the sharp decline in the Euro but a change at the margin may be occurring, which will impact investors more than businesses.
Bayer AG is taking a page out of corporate America's playbook by announcing the spin-off of its $10 billion dollar specialty plastic business, which is more capital intensive, more cyclical, and has lower margins than its pharmaceutical and consumer businesses. Great move! Others will follow.
3. The Middle East was a focal point last week as the framework for a deal with Iran over its nuclear development was reached with tremendous economic ramifications, providing the final plan is concluded and approved by summer. Secondly, the coalition led by Saudi Arabia with its Sunni neighbors included the creation of an armed force to repel the Houti/Shiite forces backed by Iran in Yemen. Where does the United States stand in all of this? Clearly our government wants to save face by reaching a deal with Iran, but at the same time Israel and the Sunni nations are against it. The United States is losing—if it hasn’t lost it already—its credibility and close relationship with many of its important allies in the region. Energy prices are caught between the potential of large additional supplies coming on the market from Iran and increased conflict between Sunnis and Shiites throughout the Middle East.
4. China continues to make additional moves to increase its status as a major player on the world scene. Last week we discussed the creation a large Asian industrial bank with many nation-partners to fund infrastructure spending in Asia to boost trade. Then, this week, China started making noises that the yuan should become a reserve currency in the world, further raising the country's stature with its trading partners. The country introduced deposit insurance in May. I’m encouraged that the Chinese government is making the right moves to support its economy and build a strong foundation for maintaining growth, around 6 percent, over the longer term.
Let's connect the dots to better understand where we are and what it means for successful global investing:
The domino effect of slowing U.S. economic growth to be felt in the financial markets will be a flattening in the yield curve; a narrowing of the interest rate differential with other countries; and a decline in the dollar, especially against the euro, but also against the yen. I would expect that the European stock markets might decline initially due to fears that their exports will be negatively impacted by a stronger euro.
Investors, looking in the rear view mirror, will fear that the U.S economy will remain weak. Interest rate forecasts will be reduced, as will be earnings estimates, and expectations for the first Fed Funds rate increase will be pushed back once again.
The economy will resume 2.5 percent to 3.0 percent growth or more in the second quarter, similar to what happened last year. Consumers, who comprise nearly 65 percent of GNP, will lead the way, followed by an increase in industrial production and capital spending. Individuals and corporations will remain lean and mean, which will prevent excesses from occurring, extending the recovery through 2016 at least. Earnings estimates for the remainder of the year and next year will be hiked, as corporations will have positive operating leverage as volume increases. But publicly, corporations will remain cautious, as it is better to beat rather than fall short of earnings projections. Commodity prices, including energy, will stay subdued, as demand growth will not outstrip growth in production.
The bottom line is that we will look back at this period as a pause that refreshes the economies and financial markets of the world.
