Economic and Market Perspectives

Q2 2015

U.S. Economic Overview

Investors in the U.S. digested a variety of economic indicators over first quarter 2015: some good and some disappointing. While U.S. economic growth moderated somewhat from previous levels, domestic equity and fixed income markets continued to build on 2014’s strong performance as the U.S. economy remains robust in comparison with the rest of the world. The U.S. dollar continued to strengthen versus foreign currencies to the disappointment of domestic multi-national firms reliant on foreign earnings and oil prices1 fell a further 13% during the quarter to $47.60, its lowest level in six years and down more than 50% since June of 2014.

Equities and Bonds
Source: Morningstar

Further mixed signals came in the form of disappointing first quarter 2015 retail sales which contributed to lowering our estimated Gross Domestic Product (GDP) from 3.00 to 2.25% on an annualized basis. Shoppers may well have stayed away from the mall in many snow-bound states during the quarter as they did in the first quarter of 2014 when GDP fell by 2.1% following poor weather only to rebound strongly for the balance of 2014. Hopefully, history will repeat itself over the course of this year.

When Good Oil Goes Bad

There appears to be no end in sight for the drop in oil prices. Production in the U.S. continues to deliver over 9 million barrels a day and members of OPEC have declined to slow production. In mid-March, the International Energy Agency reported that oil pumped into U.S. tank farms may "soon test storage capacity limits." The glut of U.S. produced oil is not surprising—with the proliferation of hydraulic fracturing (or "fracking") technology—domestic output has increased by 21% since 2013 while U.S. demand is up less than 1%. It is no wonder we are running out of room to store our black gold.

Russia, grasping at straws to help stave off recession, increased production over the quarter while slowing growth in China and other emerging economies has led to lowered overall demand growth.

The end of first quarter 2015 also saw an historic general agreement between Iran and the West on nuclear weapons. While Iranians celebrated the possible easing of sanctions pending a ratified agreement, traders pondered the impact of new supply on oil prices. Desperate for foreign currency reserves, a reduction in inflation, and a strengthening currency, Iran may well release as much as 20 million barrels of oil reserves it has kept stockpiled under the sanctions regime. Increased oil supply could further drive down prices; extending the misery low-priced oil is creating in energy exporting countries like Russia, Brazil, and Venezuela.

The impact of falling oil prices can be extreme for some economies. In Venezuela, where oil is the country's only major export, high inflation and shortages of basic goods have led to long lines at supermarkets and drug stores. In February, the country's president and authorities responded to the lines by charging and detaining store owners for destabilizing the economy in the midst of an "economic war" declared by western countries.

When Dollar Bulls Become Global Bears

Americans travelling to Europe have been delighted to find goods and services selling for far less than their U.S. prices. Many market participants, however, wish the greenback would revert to long-term levels versus the Euro, the Yen, and the Pound. Even Janet Yellen, Chairwoman of the Federal Open Market Committee, said in late March that the impact of the strong dollar on U.S. exports might produce "a notable drag this year on the outlook" for continued U.S. economic growth.

Continued U.S. Dollar Strength
Source: Federal Reserve Bank of St. Louis: trade weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners

Emerging market companies are particularly vulnerable to the U.S. dollar’s continued strength as many firms took on significant dollar-denominated debt in the last several years to fund growth at interest rates far less onerous than those of their home currencies. By one estimate from the Bank for International Settlements, some $9.2 trillion of dollar-denominated loans were outstanding from emerging market countries in September 2014—a figure up by 50% since 2009.

For some developed and emerging market companies whose revenues are primarily based on exports that are paid in U.S. dollars, the situation is less precarious as, in theory, the rising cost of their dollar-denominated debt payments should be offset by increased revenues and profits. Firms that are primarily exposed to domestic markets, unfortunately, do not have this benefit with real estate developers being a prime example due to the source of their revenues being concentrated in local currency terms.

In particular, the strong U.S. dollar is compounding already difficult conditions for real estate developers in China. These developers took on significant amounts of debt—often in offshore markets and denominated in U.S. dollars—to ramp up new home construction. Now that China's real estate market has cooled, and the Chinese renminbi has weakened versus the U.S. dollar, developers are struggling to service their debt. Early in first quarter 2015, a consortium of Chinese banks extended a $16 billion "bail-out" to one of China's largest developers. For China, however, a strong U.S. dollar is but one of the country’s economic challenges.

Contagious Contraction in China?

The Chinese government has repeatedly made it clear that it seeks to shift its economy strategically from one based on capital investment (nearly 48% of GDP) to an economy more reliant on consumer spending. (For example, some 68% of U.S. GDP is consumer-led versus approximately 52% of China’s GDP.) This is a herculean undertaking and one with a track record of considerable turmoil as exemplified when Japan and the "Asian Tigers" of Hong Kong, Singapore, South Korea, and Taiwan attempted a similar transition. The challenge for China is even greater than these countries, as none had as large a concentration of the economy in industrial production.

China's need to stimulate domestic consumption comes at a time when the country's manufacturing activity hit an 11-month low in March with a preliminary reading of the purchasing manager’s index at 49.2—below the 50-point level that distinguishes growth from contraction. Bad news also came in the form of the new orders subindex, which also hit an 11-month low, reporting a preliminary 49.3 for March. The decline in manufacturing activity has slowed job creation, as employment indices have trended lower during the same period.

Exacerbating China’s difficulties in transitioning to a consumer-led economy is the recent slide in domestic real estate prices, which has carried over into China’s other two major sources of growth—heavy industry (particularly steel manufacturing) and infrastructure projects from local governments. In a grim "perfect storm" scenario reminiscent of the U.S. housing bubble, falling demand for housing leads to weakening home prices, which in turn perpetuates slowing demand and lower prices for the steel and cement used in construction. This self-reinforcing cycle leads to more downtime at mines in China and lower employment in the service sector reliant on housing.

In terms of infrastructure spending, a decline in housing starts limits the demand for land by developers—land often sold by Chinese city and provincial governments that, in turn, use the cash to fund ambitious railroad, highway, and other infrastructure projects that employ hundreds of thousands of Chinese citizens. As steel production declines, demand for the railroad network that supplies steel mills with coal declines as well, calling into question the need for yet more rail projects.

Chinese Industrial Production
Source: Bloomberg: Index of year-on-year change in the output of industrial companies in mining, manufacturing, and utilities

Many economists predict that first quarter 2015 GDP growth will fall below the government’s 7% yearly target required to maintain employment at acceptable levels. A figure below 7% would be the slowest level of expansion in the last 25 years.

This comes despite vigorous central bank efforts to stimulate the economy, including two interest rate cuts in the last five months and efforts to boost bank lending by reducing cash reserve requirements, freeing up an additional $100 billion for businesses and consumers. But Chinese consumers, who typically invest a substantial portion of their savings in real estate, may be hesitant to tap the available credit after witnessing price declines in the once white-hot market.

Economic Conditions

With some disappointing economic indicators over the first quarter of 2015 and stagnant global growth, the Federal Reserve may be less optimistic than before about the prospects for domestic growth in coming quarters. Despite generally healthy employment levels, the Fed is acutely concerned about softening inflation and even the risk of deflation that is threatening many developing economies.

First Quarter Highlights

  • The release of March non-farm payroll growth disappointed on the downside; expectations for an increase of around 245,000 jobs were dashed by a cold water figure of only 126,000 new jobs possibly due to weather related effects and a weak energy sector. Despite the job growth disappointment of March (which snapped a 12-month run of job creation averaging 269,000 a month) overall unemployment continued to move lower at 5.5% at quarter-end versus year-end 2014’s 5.6% level.
  • Consumer spending—the primary driver of U.S. GDP—improved with a 0.1% increase in the month of February after declining in January while the preliminary estimate for first quarter average hourly earnings showed a more robust growth figure of 0.9%.
  • The weaker than expected March jobs report will prompt the Fed to pay close attention to monthly payroll figures. It is increasingly likely that the Fed will avoid a once possible June 2015 rate hike as a result of the March report.
Q2_Economic Forecasts

Fixed Income Outlook

By:David Wines

U.S. bond yields were further compressed over the first quarter as geopolitical turmoil in Yemen, Ukraine, Greece, and Russia continued to send assets seeking safe harbor to U.S. securities. Additionally, the European Central Bank's bond-buying program pushed already rock-bottom yields for European government bonds to near or below-zero levels driving further demand for relatively higher-yielding U.S. Treasuries.

A departure from the Fed-Norm?

While the Fed has indicated that it may raise short-term rates in mid-June, it is possible that subsequent increases will not follow the traditional pattern of step-wise increases following each meeting. In fact, if indicators such as job growth and inflation levels are seen as non-supportive of continued rate hikes, the Fed may pause between meetings.

An "on-again", "off-again" progression of rate hikes could create significant bond volatility as market participants may have come to expect the Fed to follow the historically consistent sequence when tightening rates. Adding possible fuel to the volatility fire are hedge funds and European investors that may decide to unwind their currency and bond positions, built up, respectively, as a result of the strong U.S. dollar and the impact of European Quantitative Easing (QE) on yields overseas.

Over the fourth quarter of 2014, we observed that the bond market seemed to have returned to its traditional, if somewhat unexciting, character following the end of U.S. QE. However, the next few quarters may well be marked by a return to a challenging environment as we enter uncharted territory marked by factors difficult to forecast, for example, the extent to which QE in Europe may support the U.S. dollar and suppress rates in the U.S. Market participants will need time to revise their expectations and execute new strategies accordingly.

Another factor contributing to market uncertainty and future inflationary pressure is the relationship between productivity, employment, and corporate spending on new equipment needed to expand operations and subsequent revenues.

As shown in the charts below, corporate cash is at a multiyear high (despite near-zero returns on cash holdings) and new orders have been soft for the last several months.

Sitting On Cash? 
Source: Bloomberg: S&P 500 Cash and Equivalents as a Percentage of Current Assets 

Recent Slump in New Orders 
Source: Bloomberg: New Orders for Capital Goods Excluding Aircraft

Meanwhile, the productivity of the American worker appears to have stalled. According to the U.S. Bureau of Economic Analysis, recent productivity growth averages 1.3%—a figure below the long-term average of 1.5% and only a marginal improvement on the 10-year average of 1.1%, which includes a significant decline during the Great Recession.

In an environment of declining new orders and strong employment growth (with some 11 million jobs added since early 2010) inflationary pressures may build. Lacking improvements in productivity, output can only increase by adding labor. With labor demand reasonably strong already, the marginal cost for labor should increase if the economy continues to expand.

Please, Loosen Your Purse Strings!

Countering concerns over the inflationary pressures that sluggish productivity growth may yield, and possibly one reason corporations are hesitant to deploy cash, is the stubborn refusal of the American consumer to spend as much as economic conditions would allow and corporate CEOs might hope for. Consumer inflation, as measured by the Personal Consumption Expenditures Deflator, shows inflation below 1.0%, year-over year, through February 2015. This figure is far below the long term trend of 3.5% and below the Fed's target of 2%. Muted consumption may counter rising labor costs and hold inflation in check.

Americans, by all measures should be spending more as we emerge from the recession. Low mortgage rates have made housing more affordable: according to the U.S. Census Bureau, the average monthly mortgage payment as a percentage of average household income is at its lowest point in decades. Low interest rates have also driven the debt burden of the average citizen to its lowest point in decades. Meanwhile, household net worth continues to improve.

Household Debt Under Control
Source: Federal Reserve Bank of St. Louis: Seasonally Adjusted Household Debt Service Payments as a Percent of Disposable Personal Income

Household Net Worth in U.S.$ bn
Source: Federal Reserve Bank of St. Louis

Even the drop in gas prices that began with the oil slump in mid-2014 had only a temporary impact on savings levels, which, according to the chart below, hit an average of 5.8% in February 2015, the highest level in two years.

Too Thrifty by Far?
Source: Federal Reserve Bank of St. Louis: Personal Savings Rate

With wage pressure growing in an environment of modest productivity gains and increasing employment, the former explanation seems more likely and is the one most favored by the Fed, corporations, and economists. Meanwhile, the next releases of data including personal consumption, employment, retail sales, new orders, and others will be closely watched as early indicators of future inflation.

Fixed Income Strategy for Q1 2015

Fixed Income Strategy

Our second quarter 2015 fixed income allocations remain unchanged from the prior quarter with overall duration slightly less than the benchmark reflecting our expectation that the economy will continue to grow, ultimately causing rates to climb. We also continue to be underweight U.S. Government bonds and mortgage-backed issues while holding a modest overweight position in U.S. corporates and municipals. High Yield bonds remain attractive due to improved valuations following the decline in the price of oil.

Equity Outlook

By: Derek Izuel

Back to the Baltics

In our third quarter 2014 Economic and Market Perspectives, we discussed using the Baltic Dry Index as a leading indicator of emerging market economic growth and one clue as to a possible attractive entry point for allocating to emerging market equities. One of the components of the Baltic Dry Index is known as the Capesize Index. This subindex measures the average daily cost of chartering the largest freighters which commonly carry raw materials such as coal, rubber, iron ore, and grain.

The Capesize Index—so named because the ships are too large to transit the Panama Canal and must travel around the Cape of Good Hope or Cape Horn to reach their destination —is a good measure of Chinese demand for raw materials (often sourced from commodity-reliant producers in the emerging markets) and an early indicator of activity in the bellwether economy.

Slumping Capesize Ship Demand
Source: Lloyds/
*An index of changes in the average daily cost of chartering a range of bulk carrier freighters of different sizes.
**An index of changes in the average daily cost of chartering a so-called capsizefreighter, currently 180,000 deadweight tons

As China’s economy cools due to cyclical factors, imports of necessary raw materials fall in tandem; for example iron ore imports are down some 9% in the month of January compared to the prior 12-months and refined gasoline and diesel fuel imports fell by nearly 38% for the same period. Emerging markets may, at some point, deserve an equal- or overweighting, but with headwinds such as declining factory activity and softening domestic demand in China, we do not feel the time is now.

Green Shoots across the Pond?

In prior Economic and Market Perspectives, we have made the case for overweighting European stocks versus domestic issues. While the European Central Bank’s QE program, which plans to purchase $65 billion worth of bonds each month until at least September 2016, has led to further U.S. dollar strength/Euro weakness and U.S. yield compression, it has also helped Eurozone economies and stock markets with MSCI Europe up some 17% for the quarter in local currency terms and 4% in U.S. dollars.

A series of positive reports boosted European stocks over the quarter including a European Commission survey that found economic sentiment in the 19-member Eurozone to be at its highest level in almost three years. At the end of first quarter 2015, a variety of indicators showed significant improvement for Europe, including:

  • Purchasing managers surveys across the Eurozone at their highest levels since 2011, including a February level of 54.1 indicating economic expansion.
  • Highest consumer confidence readings since before the 2008 global financial crisis.
  • Lower borrowing costs for Eurozone companies to support expansion.
  • Low oil prices and a strong U.S. dollar to support exports and profit margins.

Europe still faces significant hurdles including high unemployment and dangerously low inflation, but the early signs of recovery are encouraging. As shown below, European equities remain undervalued versus U.S. stocks even accounting for the recent bull market, particularly with U.S. earnings-per-share growth looking weak to possibly negative for the remainder of 2015.

Still Room for European Earnings
Source: Bloomberg

Equity Strategy for Q2 2015

Equity Strategy

The only change this quarter to our recommended portfolio weightings is a shift to an underweighting in emerging market stocks from an equal weight in first quarter 2015. Despite compelling valuations relative to developed market stocks, emerging market equities face strong structural and cyclical headwinds that could bring even more challenges to these companies. In addition to the points raised above, the decline in leading indicators for global industrial production are factors which are often closely linked to emerging market equity performance. We continue to view European equities as attractive on the basis of improving corporate fundamentals and supportive monetary policy.

David Wines, Chief Fixed Income Officer
Derek Izuel, Chief Equity Officer
HighMark Capital Management, Inc.

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