Eric J. Freedman
CAPTRUST Chief Investment Officer
“Sometimes decades pass and nothing happens; and then sometimes weeks pass and decades happen.” (Vladimir Lenin)
The Freedman household runs at a busy, often frenetic pace. My wife, Jamie, and I have demanding jobs; our three kids are spread between different high, middle, and elementary schools, and; each plays competitive sports that demand considerable travel. These factors find Jamie, the kids, and me rarely in the same place at the same time.
During a recent evening when we were all under the same roof, we introduced our seven-year-old, Conner, to the classic game Battleship. For the uninitiated, the game’s object is to guess where your opponent has placed five ships on his hidden game board faster than he can guess your ships’ locale. Both sides exchange coordinates, hoping to hear their opponent say “hit” rather than “miss.” Conner teamed up with his middle sister, Elle, and proceeded to call out his first guess, to which I replied “Miss!” I called out coordinates C7, to which Conner replied, “Miss…but you’re awfully close.” Despite pleading with an initial disapproving “Conner!” Elle couldn’t help but laugh.
Capital markets have been watching salvos of a different sort, with global central banks offering clues about their intentions. Central bank policy remains the dominant force driving markets; the European Central Bank, the Bank of China, the Bank of England, the Bank of Japan, and most prominently the U.S. Federal Reserve have dwarfed all other factors. We have seen a positive and, in our opinion, causal relationship between central banks’ asset purchase programs and riskier asset performance. When central banks have announced and carried out policies resulting in their buying of financial assets like bonds and, in some cases, stocks, both stock and bond prices have increased in value.
As a recap, global central banks acted in a coordinated fashion during the financial crisis, enacting pro-growth and pro-liquidity policies to help stabilize financial markets and heal economies. While critical events occurred before and after, those of us who lived through it cite September 2008 as the weeks where decades of radical change occurred overnight. Once-venerable investment banks disappeared into fire-sale mergers and—in one notable case—bankruptcy, lenders ceased to do business, and unemployment skyrocketed. Central banks responded by cutting interest rates and establishing asset purchase programs to replace paralyzed consumer and business demand. They also provided capital and assurances that they would be responsive to adverse developments to ensure capital markets could function.
Almost seven years after those fragile times, economies and financial markets are in disparate conditions. The U.S. and United Kingdom economies have shown signs of durable growth; members of their central banks have noted progress, but they remain concerned about stagnant price levels and low inflation. Inflation is the kinetic energy of an economy, and both central banks’ desired level is 2 percent. As Figure One shows, economies have emitted inflation levels within that range, but recent price levels are more subdued. Japan is an exception, thanks to its initial pro-growth policy implementation. Inflation expectations, which central banks emphasize when considering monetary policy decisions, also remain subdued. Low future inflation is a concern since, as the latest release of the Bank of England’s Monetary Policy Committee suggests, “lower expectations of inflation and wages might persist and become at least partly self-fulfilling.”
Japan has lived through this self-fulfilling prophecy, with its economy suffering through two decades of stagnant prices. This April marks two years since Japan embarked on unprecedented pro-growth policies. Despite recent increases noted earlier, policymakers expect Japanese consumer and producer price levels to be well below their targeted levels with no respite in sight. Japanese authorities are hoping large manufacturers will raise wages in coming months, and while higher wages could lead to more consumption, demographics make sustainably reviving that economy a challenge.
Europe, which has followed its own path since 2008, fears the Japanese experience. After years of head fakes and false promises, European Central Bank President Mario Draghi announced a $1.3 trillion stimulus program in January. The program, which runs through September 2016, emphasizes bond purchases intended to restrain borrowing costs for consumers and businesses while encouraging spending. As experienced in other economies, European stock markets have rallied in response, even amid tensions over Greece’s status in the Eurozone.
In the board game version of Battleship, the goal is to find your opponents’ ships. In the central banking version, some argue the goal is to depress your currency so that your exports become more attractive to foreign buyers, providing another demand source that could bolster your economy. Some economists argue that in the long run, a stronger currency is better than a weak one, while many central bankers appear to believe that short-term currency depreciation is a necessary first step toward stabilizing prices. The United States appeared to be in the latter camp soon after the financial crisis, with the dollar falling against its major trading partners’ currencies through the spring of 2011, rallying a little and then remaining flat for almost two years. Recently, with the Federal Reserve hinting at higher interest rates relative to Japan and Europe, the U.S. dollar has shown considerable strength. All else equal, higher interest rates in one country will result in a stronger currency for that country relative to others.
Figure Two charts the U.S. dollar against six of its major trading partners. This recent strength is just a blip. The dollar has moved up quite a bit recently, but if it retraces former levels, it can move even higher.
Just as Conner indicated when I nearly hit his battleship, market participants are parsing Fed members’ words to gauge how close they are to raising interest rates. Interest rate policy changes could affect both currencies and borrowing costs. Companies and consumers are worse off if financing corporate expansion plans or getting a mortgage become more expensive. Therefore, consistent with our view that central bank policy commands capital markets, we are paying attention too.
Is the Fed close to raising interest rates? When asked that question, Fed Chair Janet Yellen appears to be invoking Conner: We’re close, but we aren’t there yet. She and her colleagues recognize that China is transitioning to a more consumer-led economy and its growth is slowing. They realize that Japan’s process of unsticking itself may take time and that it faces a demographic headwind. On a different set of coordinates, Europe is starting pro-growth policies even while it retains rigid labor rules and generous social programs that could undermine Draghi’s efforts. The Fed may also be conscious that the U.S. economy appears to be slowing. Slower job growth, mixed consumption data, and stagnant inflation tell us that the U.S. economy does not need much, if any, coolant. Higher interest rates could further increase the dollar’s value, making U.S. goods more expensive abroad and hurting U.S. producers.
We have no “edge” in predicting when the Fed will raise rates. To us, when it moves off interest rate levels in place since December 2008, the move will be symbolic. Our chief concern, given our view that the rest of the world is unlikely to grow close to its longer-term potential, is that the Fed gets ahead of itself and moves more than needed in light of current evidence. Inflation is a high-class problem, and the conditions that would cause the Fed to embark on a prolonged inflation fight are not here yet.
Therefore, we see assets where central banks are most active as most attractive, including Europe and Japan. We don’t think the Fed will do more than a symbolic interest rate increase before year-end. As such, parts of the U.S. bond market remain attractive, particularly compared to some of their counterparts given recent price increases abroad.
We expect bond prices to fall (and bond yields to rise), but a measured Fed should make that process gradual. U.S. stocks are at least fairly valued compared to past levels, and while corporate earnings expectations are declining versus last year, with global bond yields at historically low levels, stocks could remain a worthy alternative. However, we expect more price volatility than in recent experience.
In general, our forecasts predict more subdued returns relative to history. Investors face two choices given today’s low historical interest rates and the main player in the global central bank game moving away from pro-growth policies that have supported markets: accept lower returns from existing allocations, or accept more risk in an attempt to harness returns. We still see a favorable investment landscape, albeit a rockier one than B4.
Pardon the Battleship pun. I couldn’t resist.