U.S. deleveraging is over – Since 2008, three clear overlapping waves of deleveraging have dampened U.S. growth. These started in banking before spreading to the wider private sector and then to government. Private-sector deleveraging was largely complete by 2012, with the household debt-to-GDP ratio returning to pre-boom levels and debt servicing costs falling to historic lows. But before this rebalancing had a chance to show up in stronger growth rates, the U.S. government embarked on a major fiscal squeeze. Don’t blame secular stagnation for the economy’s failure to accelerate when the Federal government tightened its structural budget by more than 2½% of GDP in 2013 alone and overall by more than 5% of GDP since 2010. Plus, local governments have added to this squeeze. Despite this, the economy has continued to grow at a rate of around 2%, pointing to decent underlying momentum. With private-sector deleveraging at an end, government austerity fading, and plenty of pent-up demand, the U.S. is on the verge of stronger, self-sustaining growth.
The U.S. equity market remains the bellwether of the world – After some stomach churning sideways volatility, this bull market will probably extend because inflation is very low virtually everywhere, monetary policy continues to be extraordinarily easy, corporate profits will chug higher, low oil and energy costs will help consumers and industry, and the chances of Fed rate hikes next year are lower. Low inflation will also aid the performance of the long end of the fixed income (bond) markets.
Still too many disbelievers after five years of Fed support – Since early 2013, stock markets have recovered strongly, with the S&P 500 up 30% and its P/E ratio having expanded by 19%. But a part of the rally in prices should be considered as a correction to the excessively high risk premium that challenged equity prices in 2011 and 2012. Even today, there are too many disbelievers, too many underweights, and too much cash on the sidelines, suggesting the rally can carry further and last longer. A half-century of fed funds rate cycles argue for overweighting equities and rate expectations suggest that policy settings will continue to support them well into 2016. A zero fed funds rate is nice but not necessary – a below-equilibrium rate is good enough – even the Fed hawks aren’t calling for restrictive policy settings.
No foundation to inflation here (nor in Europe) – Businesses and employees have little to any pricing power given excess capacities of goods and workers. The lack of expansionary fiscal policy, considerable excess capacity at home and abroad, persistent growth disappointments and a widespread lack of pricing power all argue against inflation pressures. Even if this is the year that growth finally accelerates, the still-sizable output gap offers a cushion against a sudden rise in prices. In addition, a strong U.S. dollar keeps inflation in check by lowering the cost of imported goods and commodities. In Europe, several developments will similarly suppress inflation and even create pockets of deflation. In the 1990s, a series of policy mistakes by the Japanese authorities, worsening demographics, and enormous deleveraging pressures together with a widespread credit crunch culminated in sustained price deflation in Japan. This decade, it may be the euro zone’s turn to go through a similar experience. However, so long as it is not allowed to culminate into a downward spiral in prices, very low inflation or even mild deflation may not necessarily be a bad thing for stocks.
China will support asset prices – China’s financial reforms, if fully implemented, would allow the private sector to invest freely abroad. The only way to get the exchange rate down without evident manipulation is to go full steam ahead with the liberalization of capital movements. There is little doubt that the Chinese would be happy to park huge volumes of private funds abroad as soon as the coast clears. This would be (and in some cases already is) a boon for hard assets in the U.S. and developed world. We believe that the second half of the 1990s may be a good roadmap for today’s economy. Much like the 1990s, the U.S. has been leading the rest of the world and is still strengthening amid weakness virtually everywhere else.
Michael Ashley Schulman, CFA
Hollencrest Capital Management