Posted by David Tillson 2015 First Quarter Commentary
Consider the plight of those of us born between 1946 and 1964 – the Baby Boomers. The earliest of us reached age 67 in 2013 and simple math suggests that 11,000 per day will be retiring. In the 1970’s this group was forming households and borrowing money while interest rates were rising toward 21%. Now that they are saving for retirement, rates are essentially zero. Despite being on the wrong side of the interest rate cycle over the past 60 years, this generation has still ended up controlling over 80% of personal financial assets, so at least for those who have not overspent during their adult life, all is not bad.
2015 First Quarter April 2015 If one looked only at the S&P 500 returns for the first quarter, it would appear that the market environment was quite benign. However, upon closer examination, there was a fair amount of disruption, anxiety and turmoil. Continuing terrorist attacks, falling oil prices, falling interest rates, terrible weather across the U.S., mixed economic news, the strong dollar, and concerns of Greece exiting the Euro are among the stories which kept investors on their guard. Readers of our letters know that we have had a positive view for stocks for some time. Recently some have asked if our outlook has changed. So, as Warner Wolf used to say, “Let’s go to the videotape!”
We live in an uncertain world. Policymakers have to sift through a wide range of data, much of which is subject to statistical error and measurement difficulties. Financial market participants deal with much of the same data, but also have to account for the uncertainty in how policymakers will interpret the data and respond. For the past six years the markets have been driven in large part by central banks’ quantitative easing programs, designed to entice or force investors into riskier assets thereby engendering economic growth. These ultra low interest rate policies have had the desired effect of raising asset prices and thus creating wealth. They have not had the full desired effect of increasing inflation, boosting GDP or raising employee wages. At least in the U.S, investors have generally believed that the Fed would support the financial markets – the bond market directly through their asset purchases and the stock market indirectly by assuring buyers that another meltdown was off the table. The major problem for policy makers is that while wealth has been created, it has not been spent or invested in ways that would create longer term growth in the economy.
Consumer spending accounts for 70% of GDP. Job growth has been supportive of a stronger stock market, but wage growth has been relatively lackluster over the last several quarters. The drop in gasoline prices has pushed consumer price inflation close to zero, resulting in a sharp rise in real wages. That should help drive consumer spending over the remainder of 2015 as long as oil prices do not rise materially from current levels. There has been increased social pressure for higher wages as evidenced by increases in various states’ minimum wage levels and by many companies announcing higher pay. Wal-Mart, TJX, Ikea, Starbucks, McDonalds, Gap, Costco and Whole Foods have all either announced increases in wages for their lower earning employees or already have plans that pay well above minimum levels. As long as we remain competitive with our trading partners, wage inflation which leads to higher consumer spending will be a very positive force for economic growth.
The negative impact of lower energy prices is more front-loaded, while the benefits to the consumer are likely to build over time. The sharp decline in oil prices has led to a significant contraction in oil and gas exploration. While locally severe, the loss of jobs should be small on a national level, but the bigger impact on reported GDP numbers will come through the drop in energy capital spending. Despite the contraction in energy exploration, energy extraction is still going strong, helping to keep energy prices low. Thus over the coming months, we should experience the positive impacts of low prices.
The strong dollar, up 20% since last July on a trade-weighted basis and up 25% versus the Euro, has in the near term hurt multinational companies’ earnings reports as they translate their foreign earnings back into dollars. It has also made U.S. companies somewhat less competitive versus their European and Japanese competitors. Despite this, countries are generally better off with a strong currency than a weak currency. During the last two big rallies in the dollar (1981-1985 and 1997-2001), real GDP growth in the U.S. averaged 3.6% annually and the S&P 500 rose 65% on average for each five year period.
Classical economics suggests that lower interest rates will spur spending and investment. Reduced borrowing costs make it easier for people to buy houses and companies to invest and expand; lower yields on savings cuts the incentive for people to put their money in banks and instead makes it easier to spend. Both of these behaviors eventually drive up prices and interest rates. However, in the case of ultra low interest rates, the exact opposite has occurred: under Japan’s low interest rate policy over the past 25 years, Japanese consumers spent less and actually saved more to try to prepare for retirement. According to a widely cited estimate by Swiss Re, U.S. savers have foregone some $470 billion in interest earnings since 2008. Policy makers’ ultra low interest rate policies have had the unfortunate effect of jeopardizing retirement savings and plans. Consider the plight of those of us born between 1946 and 1964 – the Baby Boomers. The earliest of us reached age 67 in 2013 and simple math suggests that 11,000 per day will be retiring. In the 1970’s this group was forming households and borrowing money while interest rates were rising toward 21%. Now that they are saving for retirement, rates are essentially zero. Despite being on the wrong side of the interest rate cycle over the past 60 years, this generation has still ended up controlling over 80% of personal financial assets, so at least for those who have not overspent during their adult life, all is not bad.
As we have discussed before, given the current state of affairs, ownership assets (stocks) remain our preferred asset class. Eventually we expect some inflation to take hold and interest rates to normalize. At that point, we could change our asset allocation guidance to a more balanced mix. For the time being, U.S. corporations are doing well: balance sheets and cash flows are strong, operations are lean and earnings are growing, albeit possibly a little below their potential. For owners, it is dividends that matter and Corporate America has continued to treat their owners well. The pattern of rising dividends continued in the first quarter as they rose nearly 15% versus the prior year.
What will the future hold? Will the next one or two decades continue on the path of the last 15 years or will it emulate the 1950’s and 1960’s? While looking only at prices may be overly simplistic, it is quite possible that the coming decade could echo the 1955-1970 period where despite rising interest rates, a strong dollar, regular recessions and social upheaval, the stock market did quite well. Recessions did occur with regularity, but the stock market’s secular trend was up. Bear markets occurred every 4-5 years and investors had to wait about 18 months before stock prices set new highs, but that was a small price to pay for the increase in wealth that fully invested portfolios attained.
This time is different. This is the New Normal. Or is it? In some respects it may be different and this period of ultra low interest rates may be “normal” for several more years. How policy makers and central banks unwind the programs that have probably saved most developed nations from a 1930’s type of catastrophe is unknown. But, these programs have bought time for everyone to recognize that political solutions must eventually be at least part of the solution; that monetary policy alone cannot solve the problems of over-spending and over-promising.
We remain optimistic, but possibly a little more watchful currently as we navigate these uncharted waters of low rates and monetary policies on steroids. In the U.S. at least, corporate balance sheets have improved, inflation is tame, we are growing faster than most of our competitors, money is cheap, the federal budget deficit is declining, and we are gaining energy independence.
In conclusion, our advice for the foreseeable future is to be prepared for potential surprises. During the past several years, many if not most of the surprises, at least for stocks, have been positive. There will be a day when the surprise is negative and the decline in stocks is sharper than people expect. To prepare for this eventuality, one should always maintain a reserve of cash that can be used for normal spending without having to sell stocks at an inopportune time. This has been our advice since we started advising clients decades ago. Investing as a career can be very humbling and anyone who takes investing seriously quickly learns that just when you think that you have it all figured out, Mr. Market throws a monkey wrench into the works. Have a plan, be vigilant, avoid greed, use common sense and be patient. Let the market work for you.