Investors had a lot of information to digest this past week, from the start of a massive QE program in the Euro zone to a new economic plan in China and finally another strong employment number in the United States.
Each one of these events not only has specific implications for their own regions but, more importantly, implications for the global economy and investing. You need a global perspective to be a successful investor. The interrelationships of economies and financial markets around the world could not have been more evident than in this past week.
Let’s take our usual look at what happened, region by region, and then discuss the implications for investing.
The events impact all asset classes, from bonds to stocks to currencies and commodities. This was an important week, as the path forward became clearer, as well as having confirmed our asset allocation and the composition of our portfolio. The perception of the implications of these events often differs from the reality of what takes place, so you need to take in all the information. So let’s step back, reflect and invest accordingly … not trade.
The ECB took center stage last week as the size, scope and specific bonds to be bought were unveiled as part of its massive quantitative easing program. Mario Draghi, president of the European Central Bank, committed to buying $66.5 billion per month of bonds of all durations until at least September 2016. I found it amazing that Draghi also mentioned that the ECB would buy bonds with negative yields. (Greek debt is excluded from the buyback.)
As expected, European bond yields hit record lows last week and the Euro fell below our initial target of 110 to the dollar. We shorted the euro at 126 and it is in print. Our next target for the euro is par with the dollar. We believe the euro will base later in the year as the European recovery becomes more self-evident and interest rates firm up. In fact, the ECB raised its growth forecasts for 2015 to 1.5 percent for 2016 to 1.9 percent and for 2017 to 2.1 percent with inflation staying below the ECB target of 2.0 percent.
It is the direction of the European economies that counts more to me at the moment than the magnitude of growth. There is clearly positive change afoot. Here, perception and reality are pretty close.
Chinese Premier Li Keqiang, at the National People’s Congress last week, officially lowered the country’s growth forecast to around 7 percent for 2015, which was a disappointment to many but no surprise to us. The general perception for most investors is that China has entered a growth recession, so commodity prices, interest rates and the yuan all fell. The government acknowledged the challenges it faces and will implement plans and new reforms over the medium and longer term to support annual growth above 6 percent, which is needed to keep unemployment down and incomes rising. Working off past excesses, strengthening the banking system and reducing pollution will restrain growth over the near term.
The perception is that China may be falling in the same economic trap as Japan did 10 years ago, but we strongly disagree. We believe that the reality will be a new norm in China, with growth above 6 percent for the next few years. What country wouldn’t like that? By the way, February exports climbed much more rapidly than anticipated and the trade surplus exceeded $60 billion just for the month. China has the needed reserves to implement positive and sustainable change.
Meanwhile, it was an interesting week in the United States. While there are many signs of economic weakness due in part to the harsh winter hurting retail sales, a decline in factory orders for the sixth month in a row, a strong dollar penalizing exports while boosting non-energy imports and a West Coast port strike, employment data reported Friday was surprising strong.
As a result, there’s a new perception that the Fed will react sooner by raising rates this summer and that excess market liquidity will ebb, interest rates will rise, the dollar will stay strong, earnings will disappoint and the financial markets will be under pressure. All of this happened in one day, based on one data point out of many that the Fed considers while deciding on its rate policies.
I disagree!
While employment rose by 295,000 jobs in February (January was revised down), hourly earnings rose a disappointing 0.1 percent, productivity declined and the labor participation rate fell to 62.9 percent. I still believe that the reality is different than the perception. The Fed will err on the side of caution and delay its first-rate increase until there are signs of improving growth overseas, a change in inflationary expectations and sustainable increases in hourly income. It’s hard to imagine that the Fed would begin raising rates as commodity prices hit new lows and the dollar new highs. The first Fed funds increase most likely won’t happen until later in the year.
So where does this leave us?
I commented last week that I would expect the financial markets to have a knee-jerk reaction and decline initially after the first Fed funds rate increase. I guess that I should have said after the perception of the first rate increase. The Fed considers many variables or data points before formulating its policy. I continue to believe that it is premature for the Fed to begin raising rates.
Let’s assume that I am wrong and the Fed moves earlier than I think. What does that mean for asset allocation and investing? First of all, it would mean that the Fed sees the economy and financial markets both here and abroad as being in good shape with mitigated risk to the global financial system. (All the banks passed the Dodd Frank annual stress tests last week.)
While the markets may say that this is the beginning of the end for the financial markets, the correct question is whether this is the beginning of a very slow process and whether the Fed will maintain a prudent policy of increasing rates slowing only as the data points dictate. I continue to believe that the economic recovery here and abroad will be slower than normal but will extend longer than usual. All good, as pressures that tend to be precursors to the beginning of the next downturn will build more slowly than normal.
My asset allocation and portfolio structure remains unaltered. If anything, I am gaining more confidence that the global economies are at an inflection point: The economies will recover slower, but will extend further than in the past; interest rates pressures will stay muted; the dollar will remain the currency of choice until growth overseas is more prevalent; commodity prices will remain weak until supply and demand get into better balance; and corporate earnings, cash flow and free cash flow will surprise on the upside.
Invest in companies creating their own destiny and going through positive change. Short those companies where managements’ have their heads in the ground and don’t see the need to change to compete in a global economy.
I cannot stress enough the need for a global perspective. All markets are interdependent: If there is a cold anywhere, it affects everyone. Most times, the perception is not the reality. Maintain liquidity to take advantage of days like Friday and remember to review the facts, step back, reflect and … invest accordingly.
