The world economy will be a tad stronger in the second quarter. Nevertheless, the slack in the G7 economies remains large, and growth will stay below potential. If China continues to deteriorate, it could snub the recent improvement in global output. This means that inflation risks are muted, creating ample room for central bank policies to stay ultra-accommodative. Asset bubbles are likely to form and select marketplaces will get frothy; we have already seen this in many NASDAQ, Internet, biotech and small cap equities which raced ahead of the broader market over the last two years, but have been punished so far in 2014. Bonds and real-estate could do well. It is too early to anticipate another major bear market so investors should stay fully invested.
Preconditions for a new recession are not in place. Private-sector balance sheets are improving, inflation is contained, and the overall level of spending in cyclically-sensitive sectors – such as consumer durables, housing, and business capital expenditure (capex) – is still fairly depressed by historic standards. There has never been a recession in the post-war era where cyclical spending was as weak as it is today. This suggests that the recovery is far from over. Indeed, after a disappointing first quarter, growth seems to be firming again.
Consensus expectations for 2014 U.S. growth have moved higher since the end of 2013 and sit at 2.7%. The good news is that there is room for U.S. GDP growth to surprise on the upside, helped by the government (fiscal) sector outlays which will grow modestly in 2014 after contracting 5% last year. This could add 1.5% to GDP growth. Broad money growth and easing of fiscal conditions should allow the economy to see a modest profit rebound which will help support stocks and other risk assets. Benign inflation is keeping bond yields below nominal GDP growth, which is conducive to higher share prices. Stocks remain in a long-term sweet spot where monetary conditions are stimulative, inflation is low, employment and household wealth are rising, and corporate profits will grow.
The “lower for longer” message is getting through to investors especially as the global economy struggles to gather momentum. The domestic economy will rebound in the second half of 2014, sending the real component of yields higher and spreads tighter; in particular, credit-sensitive sectors should continue to outperform.
- A daunting lack of belief in growth sustainability may help to keep Treasury rates low
- The consensus view is a mid-2015 liftoff and a 3.75% terminal Fed funds rate
The ‘goldilocks’ economic backdrop remains in place for spread product, none-the-less, the relative risk level of high yield (HY) corporates has increased as spreads have compressed. Better risk reward can be found in other fixed income areas such as investment grade and HY municipal bonds, commercial mortgage backed securities (CMBS), and other RE debt. In addition, floating rate debt continues to offer a viable interest rate hedge.
On the global stage, the political and civil turmoil in Ukraine won’t lead to financial or economic contagion. It is economically too small to significantly affect global markets and it has been mismanaged for so long that it is unlikely to be a catalyst for global risk. Ukraine was long ago economically overtaken by its former Iron Curtain neighbors, Poland and Romania, despite it having a substantially larger population and far greater natural resources. The only way that Ukraine can matter to global investors is if it becomes a venue for a new confrontation between Russia and the West. Any serious move by the U.S. or the EU to erode Moscow’s sphere of influence would greatly unsettle the Russian leadership and likely provoke a reaction; but neither the U.S. nor the E.U. will wage war with Russia over Ukraine. The market repercussion will only be as large as Western sanctions make them out to be; energy price volatility is the primary market concern.
Michael Ashley Schulman, CFA
Hollencrest Capital Management