The U.S. Economy
Since emerging from recession almost five years ago the U.S. economy has been through a lot. At times during this span incoming data was consistently strong such that growth appeared ready to accelerate, but there have also been occasions when the tide seemed to be going out and growth looked like it would falter.
All the while we have been steadfast in our outlook for slow domestic growth. The consistency of this view through the economic ebbs and flows is a reflection of the long-term perspective embedded in our investment process. Akin to the expression "seeing the forest through the trees", we always strive to look beyond short-term noise and recognize the bigger picture. We do this by scouring the data, but our goal is typically not to affirm the prevailing outlook. Rather, the primary focus is identifying developments that challenge our view. We ask the question: what information out there suggests that our outlook could be wrong?
Contrast this with the generally more nearsighted market consensus. In the modern information age people are most interested in what's around the next corner. Their inclination is to extrapolate the not-too-distant future using information received from the not-too-distant past. Whipsawing expectations are often the result.
As has been the case multiple times during the current expansion, periods when economic results consistently exceed consensus forecasts fuel the market's confidence that growth is ready for liftoff. Despite the fact that in every such instance substantially quicker growth failed to materialize, we again find ourselves in a situation where media chatter about breaking out of the slow growth doldrums is on the upswing. Of course it is no accident that these calls come in the wake of a string of better than expected reports on the U.S. economy.
With the aforementioned question in mind, we are not inclined to hop on the quicker growth bandwagon at this juncture. In our view, conditions in the domestic economy are certainly much better today than amid the last recession, but the environment is still far from great. We need to see further signs that "better" is transitioning to "great," otherwise we think growth will continue to bump along at a pace very similar to recent years.
For example, unemployment below 7% is a stark improvement relative to the 10% rate it peaked at in late 2009, but the domestic jobs picture remains far from great as labor force participation is hovering near multi-decade lows and income growth is anemic. To challenge our slow growth outlook we need to see evidence that continued tightening in labor markets is leading to stronger advances in wages and salaries. In such a scenario, the added consumer wherewithal should help to boost spending, and ultimately, the U.S. economic growth rate.
Sticking with the consumer for a moment, accelerating credit growth is another potential challenge to the slow growth view that has yet to transpire. Borrowers and lenders alike continued to retrench well after the recession ended, and while the latest data surrounding default and delinquency rates is encouraging, lending standards are still fairly strict and consumers' willingness to re-lever is dubious. In our view, ongoing improvement in the flow of credit around the economy represents a necessary precondition for an upgrade to the slow growth outlook.
Incoming data pertaining to business spending and investment might also nudge us away from the slow growth opinion. Like consumers, corporations became lean following the recession. Employee counts shrank, balance sheets improved via pay- downs and refinancing, and profitability soared. Corporate health is generally much better today, but the spending and investing that propels economic growth remains weak. Because growth in capital expenditures during this cycle has trailed other historical post-recessionary experiences, some pundits are comfortable making the assertion that the room for further spending will catalyze economic growth this year. We are more skeptical. It is worth noting that the "great" conditions business leaders are likely waiting on before they put their cash piles to work may never occur as demand in a slow growth world can be met with existing equipment and facilities .
The bottom line is that time and again in this economic cycle the data seemed to point toward realization of a more robust growth pace, but ultimately failed to deliver. After a series of solid reports heading into year-end, equity market weakness during January is the latest example of the risk that builds when consensus forecasts get ahead of reality. This underscores the importance of anchoring expectations and analyzing the high frequency data with a long-term perspective. Doing so provides a more objective vision of the economic landscape and will help to avoid falling prey to the endless series of disappointments and surprises that often distress investors who are overly focused on the short-term.
Global Economy A large decline in the value of Argentina's currency caught investors' attention during recent weeks after years of economic mismanagement and rampant inflation in the South American country finally came to a head. We see Argentina's situation as dire, but its significance in the global economy and financial markets is very limited. For this reason, risk of a contagion event in other economies is low, however, emerging markets in general remain under the spotlight, particularly as the U.S. Federal Reserve announced another $10 billion reduction in monthly quantitative easing following its January meeting. To the extent that sentiment surrounding emerging markets takes a step down following the developments in Argentina and the Fed decision, outflows of foreign capital could return in earnest. We should note that our view on emerging markets is little changed since the outflow trend crept-in following the Fed's hint at tapering last May. We caution against painting developing nations with a broad brush. Capital outflows will exert downward pressure on countries that need the funds most, while nations with healthy fiscal positions, limited foreign debts, and current account surpluses are in much better shape to weather the storm.
Inflation is by no means a pressing global concern at this point, but instances of isolated inflation continue to afflict emerging markets such as Brazil and India. The potential for further currency weakness across developing countries could also exacerbate inflationary pressures more broadly.
Both Brazil and India continued to tighten monetary policy during January in an effort to keep escalating prices in check. Brazil lifted its benchmark Selic interest rate for the seventh time in a row. The rate now stands at 10.50%, 325 basis points above where it was in April of last year when the shift in policy began. Brazilian consumer price inflation was advancing at a 5.91% year-over-year pace in December, clearly above the central bank's 4.50% annual inflation target. In India, central bankers raised the benchmark repo rate for the third time since September. The rate is now at 8%. Meanwhile the year-over-year change in India consumer price inflation was slightly above 11% in December.
Volatility has crept back into equity markets, as earnings season is underway and investors are working to digest the notion of less monetary assistance from the U.S. Federal Reserve. Broadly speaking, stock valuations remain elevated as compared to recent years, although with history as a guide we think the risk of a substantial and lasting correction remains quite low. This environment is conducive to active managers, as investors are rewarding companies with strong fundamentals and steering clear of weaker competitors. We continue to stress that discernment and flexibility are critical whether the focus is stocks, bonds, or both.
In managing portfolios for clients with a long investment time horizon and a need for growth to meet their objectives, our main focus is on identifying companies that can grow in an otherwise growth-challenged global economy. In many cases the companies we find most attractive have a well-established presence in faster growing regions outside of the company's country of origin, and are trading at attractive valuations relative to that growth potential. In our view, reinvestment rate risk is the main challenge facing long-term investors that need capital growth. Investors that remain on the sidelines in cash or traditionally "safe" investments are unlikely to earn absolute returns that are sufficient to meet their investment objectives.
For fixed income investors and investors with a shorter time horizon or current income needs, our focus in bond markets is centered on spread sectors (i.e., fixed income securities that trade at attractive yield spreads relative to a similar maturity Treasury). In particular, we are seeing opportunities in investment-grade corporate bonds. A selective approach to the below investment-grade corporate space is helping us find value there as well, however opportunities are becoming more scarce as investors reach for yield. With regard to government debt, we continue to favor Agencies over Treasuries. In an effort to limit the sensitivity of clients' fixed income investments to a rising rate environment, portfolios are tilted toward shorter duration securities. In our view, short-term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows, and pay an attractive dividend could be compelling options for these types of investors in the current environment.
Analysis: Manning & Napier Advisors, LLC (Manning & Napier).
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