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From Ultra to Extremely?

First Quarter 2015

Download PDFCapital Investment Services First Quarter 2015 Perspective - From Ultra to Extremely?

Cartoon: Fortune teller uses a direct phone line Janet Yellen for forecasting
Down, up, down.

That has been the monthly pattern for U.S. stock market averages and bond yields so far this year. The choppy pattern simply mirrors the many crosscurrents that have emerged to confront investors.

Among the crosscurrents:

  • The Yellen-led Federal Reserve (Fed) signaled intentions to raise interest rates for the first time in nearly a decade.
  • Some fret that such change in policy risks repeating Fed errors of 1937. Back then the Fed tightened policy and both the economy and stock market suffered their second violent downturns of the Great Depression era.
  • Continued general weakness in commodity prices seems to reinforce the worry for some that deflation indeed remains a material investment/economic risk.
  • Meanwhile, economic indicators suggest domestic growth slowed substantially in the past quarter. Weaker data helped erode already-fragile confidence among many economists and analysts about the path of the economy.
  • Despite the apparent economic weakness, McDonalds, Walmart, T.J. Maxx, Target and others announced pay raises for staff.
  • Cartoon: Wages apper to be on the rise
  • In contrast to the apparent policy direction implied by the Fed’s intentions, their European Central Bank (ECB) counterparts went the ‘other way’ and eased by implementing an aggressive bond buying program designed to boost Eurozone economies.
  • Greece again emerged as a potential threat to destabilize the Euro.
  • The exchange value of the dollar surged. Analysts worry foreign currency translations will reduce 1st quarter corporate earnings releases due out soon. Earnings reports were already widely expected to be weak because of lower oil company earnings.
  • Unrest within the Middle East intensified as terrorists provoked actions from and within Egypt, Saudi Arabia, Yemen and Iraq.
  • A “deal” with Iran on nuclear enrichment either increases or decreases their capabilities depending upon which assessments one reads.

Addressing the crosscurrents

What’s likely to happen with geopolitical events? We wish a good fortune teller was available. One can be pretty certain, however, that they will continue to cause investment angst and periodically roil the markets. Given their unpredictable nature, investors can cope through appropriate bond/stock allocations and by remaining vigilant.

When it comes to the prevailing economic crosscurrents highlighted earlier, we believe we have much more perspective to offer.

Trend change transition

Many of the economic crosscurrents are symptomatic of the unfolding major changes in investment trends which we have been discussing for some time now.

The primary investment trends of recent years had been aptly summarized by the phrases commodity super-cycle and the emerging markets century.

However, with China now wrestling with massive debt accumulation and a major infrastructure overbuild, things have changed. Its slower, less commodity-intensive growth has taken much of the wind from the sails of the super-cycle and emerging market investment trends.

China’s slowdown is not occurring in a vacuum. Slower growth and/or recessions have set in at other countries that had been beneficiaries of surging commodity prices (Brazil, Russia and even Australia and Canada). Commodity price weakness has, in some instances, revealed structural economic issues within many countries that will not likely be quickly remedied.

As hard as it is for some to believe, the investment growth baton has shifted in favor of the U.S. and U.S.- traded stocks (see Chart 1 below).

Chart 1: Earnings growth in U.S. (S&P 500 EPS) exceeding growth in emerging markets (EM)
Chart1: Emerging markets company earnings growth appears to have decoupled from U.S. companies 2005-2015

The catalysts for the trend changes include:

  • The U.S. economy has dealt with many of the issues that helped set the stage for the 2008 Financial Panic. The banking system is now better capitalized than it has been in decades, consumer debt burdens are generally modest, the savings rate is higher than it has been in generations and companies are generating abundant amounts of cash.
  • In addition, innovation and the technology revolution continue to be at the forefront of U.S. economic dynamism. Such dynamism is lacking in most countries around the globe. The innovation trends are most visible perhaps in medicine (biotech and life sciences), and manufacturing, where a renaissance of sorts is underway as that sector continues to grow faster than the economy at large.
  • Innovation bodes well for productivity growth as an important growth driver. The Internet of Things, 3-D printing, direct digital manufacturing, software simulation, cloud computing and advances in material sciences all hold promise for new and significant productivity tools.
  • U.S. demographics remain more favorable for growth than much of the rest of the world (see Chart 2).
    Chart 2: Favorable demographics for the U.S.
    Chart2: Projected change in working age population 2012-2050 U.S. is positioned favorably relative to other developed countries

    Like productivity growth, demographics can have an important influence on economic growth. In Japan and the Euro Zone, despite troubling tax and regulatory burdens (Washington D.C. take note), unfavorable demographics are also playing significant roles. Easy monetary policy alone cannot overcome such headwinds.

    The U.S. demographic tailwind is slowly building momentum. The group born after 1980 now exceeds the baby boom in number, and their economic impact is likely to be significant. This demographic age group tends to create the greatest number of new businesses, and purchase the greatest number of autos, homes and home furnishings.

    Chart 3: New highs!
    Chart6: Number of Employed U.S. 25-34 Age Demographic

    Spending requires income of course, and the good news is employment within this group is now at all-time highs.

    And despite what some of the daily headlines might suggest, good paying jobs are being created.

    Chart 4: It’s likely better than many believe
    Mainly high wage jobs have been created during the U.S. economic recovery

    Meanwhile, a stronger dollar is likely to remain a byproduct of the shift in trends we perceive. As reflected in the table below, dollar strength certainly did not derail economic growth or halt stock bull markets in the past. We don’t expect it to in the current situation either.

    Commentary and Data from Evercore/ ISI
    Over the past 40 years, the dollar has staged two major, multi-year advances. Both were associated with stock market surges, although with major drawdowns during both episodes.


    Dollar appreciation +50%
    S&P increase +100%


    Dollar appreciation +30%
    S&P 500 increase +180%

    The incipient trends have not yet reached full blossom, nor are they widely accepted at this point. From an investor’s perspective this is good news, for the trends are far from being fully exploited in terms of investment potential.

    Until the trends become more vigorous and obvious, investor confidence will mostly float with the ebb and flow of economic data releases. Economic releases so far this year have not been confidence-inspiring.

    Distorted 1st quarter economic data

    The impact last year of severe winter weather on economic data was significant with 2014’s first quarter real GDP reported in decline. The weather-induced dip proved transitory, but many found it difficult at the time to separate an economic signal from the noise of weather.

    A repeat of sorts is likely underway in 2015. Regarding this year’s first quarter, economist Brian Wesbury provides some important context:

    Retail sales were weak, except for buying over the internet and by mail-order. Utilities soared at the fastest pace in more than 40 years, while manufacturing production fell. And now housing starts plummeted at the second fastest pace in the last twenty years.

    If it wasn’t obvious already, it should be now: the coldest February temperatures for the most people since 1979 had a huge (but temporary) effect on the economy. In fact, Americans in 23 states experienced a “top-10-coldest February” going all the way back to 1895.

    The economic tea leaves were also likely impacted unfavorably by the West Coast port strikes in January and February. Wesbury also provides meaningful insight on the impact of the strikes:

    The total number of inbound and outbound containers was down 10.2% from a year ago at the Port of Los Angeles and down 20.1% at the Port of Long Beach.

    With spring weather now upon the country and with resolution of the port strikes, these factors should no longer be playing havoc with commerce (and economic data).

    We do not believe the weak economic readings so far this year are signaling an end to the economic expansion. Nor are they indicative of conditions that will prove a lasting threat to corporate earnings growth for many companies.

    1937 Fed jumped on the brakes

    To assess whether a Fed interest rate hike runs the risk of unleashing a 1937-like downturn, let’s take a trip back to the 1930s for a few moments. The Great Depression was marked by two significant contractions in the economy. These downturns were triggered by two sharp contractions in the money supply as Chart 5 indicates.

    Chart 5: 1930s like contractions in money and the economy not ahead
    Annual rate of change U.S. M2 money supply 1900-2014

    Economic activity collapsed during 1930-33 as the banking system imploded and the money supply registered the largest contraction in U.S. history. Ben Bernanke made sure the Fed did not repeat that mistake during the Financial Panic of 2008 and its aftermath.

    The money contraction of 1937 was not nearly as severe as the 1930-33 episode (thankfully!), but it still is one of the sharpest declines presided over by the Federal Reserve. Like the contraction disaster earlier in the decade, it, too, was the result of significant monetary policy mistakes.

    The 1937 monetary contraction and accompanying nasty recession were preceded by tax hikes and two methods of policy tightening by the Fed—rate hikes and substantial increases in reserve requirements imposed upon the banking system.

    The reserve requirement policy “tool” reflected new powers granted to the Fed and their inexperience with its use created trouble. When the Fed became worried about the economy’s inflationary potential following the vigorous economic rebound of 1934-36, the degree of tightening they undertook using the reserve requirement tool was likely not well understood. One study of the Fed’s actions at the times summarized it as follows:1

    On the basis of well-intentioned ignorance, the first increase in reserve requirements could be forgiven.

    The second round of increases in March and May 1937, however, turned what had been an ongoing recovery into another cyclical disaster. “Inflationary” potential came down to –20.5 percent, and all the leading indicators of business activity turned negative. By September the recession was unmistakable.

    No inflation of any size could have occurred between 1937 and 1941. What did appear as a result of Fed-Treasury policies was a sharp recession that further undermined confidence in the market system.

    In summary: the Fed of 1937 jumped on the monetary brakes and economic activity collapsed. Unlike back then, we don’t have tax hikes on the table and the Fed won’t be doing any brake jumping.

    As current Fed Vice-Chair Stanley Fischer put it (and the source of the title for this Perspective by the way):

    We will be moving from an ultra-expansionary monetary policy to an extremely-expansionary monetary policy.

    Unlike his 1930s counterparts, Fischer is anything but an inexperienced central banker. He earned accolades for his years of monetary stewardship as Governor of the Central Bank of Israel and is mentor to current and former central bankers Yellen, Bernanke and the ECB’s Mario Draghi.

    With inflation a non-issue today, why should the Fed even risk any hikes?

    The current zero-interest-rate policy was in response to an economy in crisis. Yes, the economy is far from robust. But the economy is no longer in crisis.

    The factors holding the economy back—excessive regulation and taxation—cannot be solved by ultra-expansionary money policy. Incremental policy moves now may prevent the risk of brake jumping later on.

    Unintended consequences and the potential for a monetary policy misstep exist. The dramatic increase in the size of its balance sheet as a result of its ultra- stance puts the Fed in unchartered waters. But the risk of a 1937 repeat is a low-probability scenario.

    Stock market pullbacks and the rate hikes

    Last quarter we reproduced the following chart which displays yearly returns for the S&P 500 Stock Index.

    S&P 500 year over year percent change showing recesssions and fed tightening from 1969 to 2014

    The chart helps make two important points. First, stock “bear markets” (periods of prolonged, gut wrenching negative stock returns) typically are triggered by corporate earnings stressed by economic recession (shaded bar areas in chart).

    Secondly, stock returns often—though not always—also struggle in years in which the Fed tightens policy.

    What, if anything, do these historical patterns portend for the current environment?

    The present slow-growth economy is marked by few of the growth-threatening excesses that precede recession. As a result, the next recession (and bear market–hopefully) is likely some years away yet. Economists at Evercore/ISI suggest the next recession could be five or more years away. Their guideposts follow:

    • Recessions typically start roughly five years after the Fed starts to tighten. (Does Fed move from ultra to extremely qualify as “tightening”?)
    • Recessions typically start roughly five years after wages start to accelerate. (Wages starting to accelerate in 2015?)
    • Recessions typically start roughly seven years after housing starts move well over 1 million. (Housing starts may reach the 1 million threshold this year or next)

    Whether or not the stock market suffers a pullback this time as the Fed exits crisis policy mode remains to be seen. However, if it does, history suggests the pullback won’t be fun but will be relatively short lived and investors will be well compensated soon after.

    Deflation—how real a threat?

    Cartoon: Deflation appears larger than life - a looming monster compared to fed rate hikes
    Before we put this Perspective to bed, we are compelled to briefly return to the deflation topic. As one economist stated recently, “Deflation remains the looming zombie apocalypse of international monetary commentary”.2 It strikes us that the fears of deflation and its risk to the U.S. economy are largely overblown. Talk of a “deflationary undertow”, a “deflationary mindset spreading among consumers” and “debt deflation” is common today. This cartoon likely captures the typical view of the impact of deflation on an economy.

    What is deflation, anyhow? Former Philadelphia Fed President Charles Plosser noted in a 2003 study of its history,3 that deflation is a sustained decline in the general level of prices. Individual prices can and often do vary, but sustained declines in prices across and economy are relatively uncommon events.

    Plosser concludes:

    The claims that deflation is a recipe for economic catastrophe are not well supported by the historical record or recent experience. Much of the case for such doom and gloom rests on one episode, the Great Depression. Other episodes of modest deflation, less than 2% (per annum) seem consistent with continued economic growth.

    Plosser’s conclusions are supported by a more recent study of deflationary episodes across history and countries.4

    The most salient points of the latter study:

    Concerns about deflation – falling prices of goods and services – have loomed large in recent policy discussions. The debate is shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion.

    (Yet) in the postwar era, in which transitory deflations dominate, the (economic) growth rate has actually been higher during deflation years, at 3.2% versus 2.7%.

    The almost reflexive association of deflation with economic weakness is easily explained. It is rooted in the view that deflation signals an aggregate demand shortfall, which simultaneously pushes down prices, incomes and output. But deflation may also result from increased supply. Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labor or intermediate goods like oil. Supply-driven deflations depress prices while raising incomes and output.

    In other words, most of the time deflation has been a good thing. When it is the result of innovation that increases the availability of goods or services to more people, it can stimulate growth. If we are right about technology and manufacturing delivering innovative new tools that enhance productivity growth, deflation in the present context is to be cheered, not feared.

    The ruinous deflation is that which was experienced and nearly exclusively confined to the 1930s. But that deflation was the direct result of colossal monetary mistakes by the Federal Reserve. A repeat of such mistakes under an ultra to extremely Fed policy transition—as we noted earlier—is a low probability event.

    The economic expansion and the stock market bull very likely have more room to run.

    As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success.

    Sources & Notes

    1 The Reserve Requirement Debacle of 1935–1938, Richard Timberlake, The Independent Institute, June, 1999
    2 The Grumpy Economist blog, John Cochrane, University of Chicago, March 20, 2015
    3 Deflating Deflationary Fears, Charles Plosser, University of Rochester, November 2003
    4 The Costs of Deflations: a Historical Perspective, Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann, Bank for International Settlements, March 2015