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Per Stirling Capital Outlook – August 2014

In the July edition of this publication, we used the following chart to raise the question of whether or not the financial crisis had caused long-term structural changes to the domestic economy in general, and to the long-term growth potential of the U.S. economy in particular. This chart compares actual inflation-adjusted economic growth to the presumed long-term growth potential of the domestic economy.

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Long-term economic growth potential is determined by a great many factors, including industrial capacity, labor productivity, demographics and technological innovation. However, the single most important determinant is probably just how fast the economy can grow without causing unwanted levels of inflation, and thus catalyzing the Federal Reserve to slow growth (through higher interest rates and restrictive money supply), as a means of dampening the inflationary threat.

The above chart illustrates that the domestic economy has grown at well below presumed potential ever since the depths of the financial crisis. This general theme is also echoed both in the below chart, which shows that the current recovery has produced the lowest levels of wage growth since 1949, and the chart at the top of page two, which shows that this has been the slowest recovery overall from a recession since 1950.

Indeed, according to an August survey performed by Rutgers University, 42% of Americans maintain that they have less pay and less savings than before the recession began in 2007, and only 7% say that they are “significantly better off” than in 2007. Even former Federal Reserve Chairman Ben Bernanke has been reassessing the impact of the financial crisis, and stated in court documents on August 22nd that, “September and October of 2008 was the worst financial crisis in global history, including the Great Depression.”

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Obviously, something is different this time, and we believe that this difference has enormous implications for both monetary and fiscal policy and, by implication, the outlook for both the equity and debt markets.

Indeed, when we first introduced this issue of potential structural changes to the economy in the July Per Stirling Capital Outlook, it was largely posed as an academic question. However, on August 23rd, Federal Reserve Chairwoman Janet Yellen took the opportunity of the Jackson Hole Economic Summit to raise this issue from being a primarily academic one to one that may ultimately prove to be the lynchpin of the outlook for both economic growth and inflation.

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In her speech, Chairwoman Yellen posed the rather esoteric question of whether the much weaker-than-average characteristics of this recovery are structural or cyclical in nature. In other words, are they being caused by issues related to the business cycle (cyclical), or should they be attributed to longer-term structural changes in the economy due to, for example, the country’s ballooning debt burden, changes in the labor force, the burdensome levels of new regulation, or some other cause or causes.

This question is of critical importance as, while monetary policy can have a direct impact on cyclical issues, it is largely ineffective in regard to structural issues. Indeed, there is a significant inflationary risk if the Federal Reserve continues to use extraordinarily accommodative monetary policies in an effort to accelerate the economy to its historic levels of potential growth, if it turns out that structural influences have essentially lowered the economy’s non-inflationary “speed limit”. Such an error would likely cause both “demand push” and “wage pull” inflation.

One good example of a structural, as opposed to cyclical, influence can be found in the below chart of domestic job openings, which are literally surging. However, many jobs are being left unfilled because of the current “skills gap”. In short, a significant number of American workers simply lack the skills and education necessary to perform many of the jobs being created in today’s economic recovery, and there is no amount of monetary stimulus that the Federal reserve can throw at the problem to solve this issue. If anything, they run a real risk of creating wage inflation if they attempt to solve such a structural issue with a cyclical monetary policy solution.

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Indeed, the irony is that, if they attempt to address secular, structural issues with traditional monetary policy tools (or even unconventional ones like Quantitative Easing) they risk creating an inflationary environment that would force them to take the steps necessary to slow down the very economic recovery that they are trying to stimulate.

This is why the cyclical versus structural debate is of such critical importance. Ultimately, the answer to this question will only evidence itself over the course of time. However, we do know that it is presently a point of contentious debate at the Federal Reserve. We also know that many Americans believe that there has been a structural change in potential economic growth, which is evidenced in a Rutgers University survey that was released on August 28th, and which revealed that 71% of Americans believe that the financial crisis has “exerted a permanent drag on the economy”. This is in contrast to only 49% of respondents that held that opinion in November of 2009 (five months after the recession actually ended). Ironically, this was also when the unemployment rate was a massive 9.9%, as opposed to the current 6.2%.

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Despite this uncertainty, there are certain related issues that we believe that we can be much more confident about. For example, while inflation is starting to run above the Federal Reserve’s 2% target rate, there are almost no signs of runaway inflation being an imminent risk. Wage inflation is virtually non-existent (see the bottom chart on page one) and capacity utilization (above) remains below 80% of perceived capacity. This should provide investors with some degree of comfort that the Fed’s current efforts to stimulate the economy are not posing an imminent inflationary threat.
On the other hand, the dramatic drop-off in worker productivity (output per hour worked) is quite disturbing, as strong productivity gains allow workers to improve their standard of living through higher wages without creating inflation in the overall economy. According to former Dallas Federal Reserve President Bob McTeer, after a dramatic surge in late 2009 and 2010, productivity gains have been absolutely pathetic over recent years, with average gains of less than 1% in 2011, 2012, and 2013, and a massive 6.5% productivity decline in the first quarter of 2014. This drop in productivity is a real concern, as without continued productivity gains, it is very difficult to close the wealth gap in America. While not an imminent inflationary threat, changes in productivity levels certainly bear close watching.

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While the past is not necessarily prelude, something else that we can feel pretty comfortable about is how markets have historically reacted once the Federal Reserve does ultimately take the proverbial “punch bowl” away (i.e. changes course from an accommodative, easy money policy to a more restrictive one).

First of all, in regard to the bond markets, we believe that prices have been driven to extreme highs (and yields to extreme lows) as a result of deflationary pressures in Europe and a flight to safety from geopolitical risks (Russia, Ukraine, Iraq, Syria, Israel, Gaza, etc.), which should make bond prices very susceptible to a quite significant decline once geopolitical risks recede or the Federal Reserve starts to either raise rates or reduce monetary liquidity (neither of which seem to be an imminent threat).

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Moreover, as illustrated in the very counter-intuitive chart above, bond yields have actually moved in near lock-step with the size of the Federal Reserve’s balance sheet, which suggests to us that the ultimate shrinking of the Fed balance sheet may help to cushion any decline in the bond markets. The same can be said of the ridiculously low sovereign debt yields in Europe. All in all, we believe that investing in most bond markets around the world will prove to be a terrible long-term investment, but that it may still be some time before the “piper” ultimately needs to be paid.

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The equity markets have also moved in near lock-step with the size of the Federal Reserve’s balance sheet which, in contrast to the bond markets, suggests that the eventual shrinking of the Fed’s balance sheet should serve as a significant headwind in the face of the equity markets. The same can be said of the eventual increases in interest rates which, as illustrated above, have historically muted equity market returns.

However, on a positive note, the domestic equity markets should benefit greatly from the ongoing recovery in both the U.S. economy and domestic corporate revenues and profits. Indeed, over the past quarter, 68% of stocks in the S&P 500 Index have exceeded earnings expectation and 55% have exceeded revenue expectations.

Moreover, there is an increasingly compelling technical argument that the domestic equity markets have actually broken out of a fourteen-year long trading range and started a long-term secular advance that may dwarf the importance of many of the aforementioned concerns.

To explain, if you look at long-term charts of the equity markets, there is a historical tendency for stocks to experience multi-decade secular bull markets, which are followed by ten-to-fifteen-year consolidation periods, when equity markets trade sideways and digest their gains. These are reflected in the peach-colored boxes to the left. The vertical, grey, shaded areas indicate recessions.

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While, as noted above, the past is not necessarily prelude, and while cyclical (economically-driven) bear markets do take place within the confines of secular bull market moves, we believe that the repetition of this historical trading pattern is at least a viable possibility now that equities have finally emerged from their 2000-2014 consolidation (sideways-trading) period.

Admittedly, it may seem like a little bit of a stretch to introduce such a potentially bullish scenario at a time when the domestic equity markets have already rallied strongly for over five years, and when equity valuations (even relative to such historically low interest rates) are at rather lofty levels. However, it is important to remember that it is excessively bullish sentiment rather than time or valuation which normally kills bull markets. Put another way, it is when there are no longer any more bears remaining that can be converted into bulls, and when you see anecdotal evidence like the proverbial taxi driver or shoeshine man giving out stock tips that equity bull markets are normally at risk. We see almost no signs of this speculative froth in today’s markets. If anything, we are seeing the exact opposite.

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Indeed, Americans have $10.8 trillion parked in cash, bank accounts and money-market funds that pay little or no interest. This totals 84.5% of annual disposable personal income, which is the highest percentage in 23 years. Moreover, a recent Gallup poll revealed that only 7% of those surveyed were even aware of last year’s 30% gains in the Standard & Poor’s 500 Index, and that 37% of respondents believe that the market rose only 10% last year while 9% believe that the equity markets actually fell last year.

This survey, which was limited to investors with at least $10,000 in stocks, bonds, mutual funds or in retirement programs, further found that, given a choice of what to do with an extra $10,000, 36% said they would keep it in cash and 20% chose the low yields of a certificate of deposit.

From our perspective, this evidence suggests that there are still an enormous number of bears remaining, who have yet to be converted to bulls, and that current sentiment is the polar opposite of the type of speculative froth that normally marks the end of equity market advances.

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In the current environment, one could easily make the argument that even more compelling opportunities exist in the foreign equity markets, particularly in light of the much less expensive valuations (see below) and European Central Bank (ECB) President Draghi’s renewed commitment at the Jackson Hole Economic Summit to “use all of the available instruments needed to ensure price stability over the medium term”, which many interpret as an indication of the ECB’s commitment to introduce an American-style quantitative easing program. We agree that this approach may indeed make sense for a patient, long-term, and value-oriented investor.

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However, in light of the questionable impact of “Abenomics” in Japan, Russia’s increasingly aggressive tactics in Eastern Europe, and the increasingly onerous sanctions that are likely to be imposed on Russia by both the European Union and the United States (which are likely to hurt the European economy as much as that of Russia), we believe that, from a more tactical perspective, it makes sense for any investor seeking to maximize intermediate-term, risk-adjusted returns to focus increasingly on the domestic markets.

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The one exception to this general perspective may be the world’s emerging markets (ex-Russia), with their improving economic fundamentals, their attractive valuations, and their ability to remain relatively detached from the current geopolitical fray.