Prudent is not just a word: It is the basis of the new Fed policy.
The Fed changed its message after its March policy meeting last week ever so slightly, but meaningfully, by substituting the word "prudent" for the word "patient."
While the meaning of the policy change was ever so slight, if it amounted to a change at all, it had a significant impact on all financial markets. The dollar fell, bond markets and stock markets rallied and there was a deep sigh of relief by investors worldwide.
As we mentioned last week, the scale tilted heavily towards the Fed maintaining its overly easy monetary policy as the recent data points indicate near-term economic weakness due to the unusually harsh winter, the strength of the dollar, weakness overseas, declining commodity prices and the widening interest rate differential. No surprises here. Now that this hurdle is behind us, it's time to focus on the future and how to profit from the correct asset allocation, the correct regional exposure and the correct investments, both long and short.
If you have the time, you may consider reading two short pieces that I wrote last week. The first was titled "Survival of the Fittest" and dealt with how the well financed and companies with low cost of production, such as Exxon Mobil, Halliburton, Rio Tinto and BHP Billiton, are playing the long ball and poised to benefit from declining prices as the marginal producers are forced to sell assets and/or enter bankruptcy. This game has been played many times before. By the way, these companies have very high and well-supported dividends while you wait for the turn in commodity prices.
The second piece was titled "Look Over the Valley," which points out that weak first quarter earnings for many companies will be an aberration due to the harsh winter, a strong dollar (which hurts reported dollar earnings), dumping by foreign competition at prices beneath cash costs of production and the west coast dock strike. If opportunities to invest in strong companies with sound strategies and investor-friendly managements can be created at lower prices as a result of disappointing first quarter earnings, I'd be a buyer, as these companies’ results will improve and normalize as we move past the valley.
This was a very important week as events both here and abroad reinforced my view that we are at an inflection point for world economic activity, albeit slower than in the past, but not all that bad. In addition, many longer-term issues are being addressed in some countries that will help build a stronger foundation for future growth. I wish that I could include the United States in that list, but our federal government is too focused on politics rather than governing. Gridlock is the best that we can get for now. Sad but true.
Let's review of the past week's events and their implications for the foreseeable future in the United States. The anticipation of a change in the language of Fed policy was clearly a key event. The market declined when the word "patient" was removed in regard to maintaining monetary policy. But after "prudent" was inserted and the Fed lowered its interest rate assumptions meaningfully for both this year and next, the markets switched gears fast.
The median forecast for the Fed funds rate dropped 50 basis points to 0.625 percent for year-end 2015 and down 62.5 basis points to 1.875 percent for year-end 2016. What else did the markets have to see? The yield curve flattened, the interest rate differential narrowed, the dollar fell and the equity markets rose.
The new assumption was that the Fed would hold off until fall at the earliest to begin raising the funds rate for all the reasons that we enumerated last week. Naturally, this can change was based on future data points. The Fed is doing the right thing by remaining cautious, as it needs more proof that the economies both here and abroad are really doing better and are in recoveries that are sustainable. "Prudent" is the new key word for the Fed.
The OECD raised its forecast for global economic activity for this year and next primarily due to the positive effect on consumer spending by lower energy prices. Sound familiar? The Eurozone received the largest percentage increase and the OECD is now forecasting growth of 1.4 percent in 2015, up from 1.0 percent previously, and 2.0 percent in 2016, up from 1.7 percent previously. The main driver besides lower energy prices is the positive impact of QE and higher exports due to a lower euro. We agree. It really is the direction and positive marginal change that counts more than the magnitude of growth for investing.
The euro rallied at the end of the week as fears of the Fed raising rates abated and the interest rate differential narrowed. I still expect a weak euro to persist over the next few months as the U.S economy picks up steam once again in the second quarter. There are too many structural issues remaining in Europe and questions about Greece and the weaker nations for euro strength to persist. The ECB, especially Germany, face a dilemma in dealing with Greece: On one hand, everyone knows that Greece won't strictly adhere to its agreements on austerity. But on the other hand, Greece is an important catalyst in maintaining a weak euro, which benefits strong countries such as Germany. Focus on the improvement in economic activity in the Eurozone.
I want to applaud the positive actions going on in Japan. Yes, we know that QE has helped weaken the yen and boost exports, which was the initial goal to support growth. But the government, led by Prime Minister Shinzō Abe, recognizes that this is a stop-gap measure and that real change needs to occur for sustainable growth. Many structural and regulatory changes are being implemented and the call that companies meaningfully raise wages is being met. Japanese companies almost across the board are raising wages the most in 12 years and well above the real inflation rate. Consumer demand will benefit from higher income and lower energy costs. The OECD raised its growth forecast for Japan to 1.0 percent this year and 1.4 percent in 2016. A sound foundation is being built so the country can attack its large debt load in a meaningfully way. Things are getting better at the margin and I am less bearish longer term on Japan.
While most economists are pessimistic on China's future, I believe that they are missing the boat as the government continues to implement financial and regulatory policy changes that will help build a sound foundation for future growth, albeit less than 7 percent. It is interesting to note that the Chinese stock market hit a multi-year high last week while the government supported the yuan rather than letting it fall further. The government is bent on building a sound foundation for future growth tied more toward domestic demand than relying on exports. Infrastructure spending will be a major component of their plan. Positive change is on the horizon.
Prime Minister Narendra Modi and his government have embarked on a number of policy initiatives in India to accelerate growth for the foreseeable future. While the government is out with forecasts of economic growth exceeding 8 percent over the next two years, I agree more with the IMF forecasts of closer to 7.2 percent to 7.5 percent for the next two years. India will add significantly to overall global economic activity as the second largest population in the world.
Let's wrap this up and go to the crux on the investing dilemma: When will good news be good news for investing or do we need continued economic weakness with virtually no inflation for the financial markets to perform well?
Everyone says that they want economic growth and some inflation. Pro-growth monetary and fiscal policies continue to be implemented, but the bond markets around the world don't seem to believe in it. Why? I believe that the inflationary pressures are being held down by the huge decline in energy prices and industrial commodity prices—by low wage rate increases; by the impact on the Internet on pricing for goods ranging from cars to toilet paper and, finally and most importantly, by globalization. Prices are forced down to the lowest common denominators unless there is a measureable difference. Why do you believe Apple can get $600 for its cell phone while the average price for cell phones worldwide is less than $40?
The next point to consider is that while all these pro-growth policies are being enacted, the financial regulators continue to mandate lower leverage and higher capital ratios at all financial institutions. As I have said before, one hand giveth while the other hand taketh away. Debt is not as good in a low inflationary world. Think about that.
So, where does it leave us? We are going to live through a period of less nominal and real growth for reasons mentioned above. Currency moves will shift as there are ebbs and flows in economic activity by region. Now, the time is right for the dollar. Global interest rates will stay subdued and the yield curve will remain flatter than the norm as inflationary fears stay muted. I believe that corporate profits will surprise on the upside, as will returns on capital, as corporations adapt to this new world. Invest in market leaders that are shareholder friendly with strong financials, technological advantages and low cost positions. And short the tertiary players.
Patience and prudence are needed to be a successful investor. Maintain liquidity at all times to take advantage of sudden market moves down. And as always remember to review all the facts, step back, reflect and … invest accordingly!
