Fed-Up

The markets continued to suffer from some short-term volatility after the Fed’s decision not to increase interest rates. While low interest rates are normally viewed as favorable for stocks, that changes when investors sour on the economic outlook – specifically, the global economic outlook. Investors now seem bitter over the failure of the Fed to raise rates in the middle of the fallout from emerging markets and China. Nevertheless, Fed officials continue to insist that a rate increase this year remains a decent possibility.

In prepared remarks last Thursday, Janet Yellen said she personally believes “it will likely be appropriate” to raise the fed funds rate this year and “continue boosting short-term rates at a gradual pace.”  She also said, “Prospects for the U.S. economy generally appear solid” and the first rise in the fed funds rate “should have only minor implications for financial conditions” and the economy.

I actually think she’s probably right.

Current concerns surrounding weakness in emerging markets and China have generated discussions about the potential for economic weakness to infect developed economies (economies with relatively high levels of economic growth, like the U.S., Canada and big European countries) by way of trade. One thing for investors to remember is that that developed market growth does not really tend to be driven by manufacturing as much as it is by services.  This means that they are less exposed to exports/trade. Also keep in mind that outperformance in the service-oriented areas of an economy is a very stout signal for overall growth.  Service-related industries in developed markets, particularly in Europe, appear to have grown much faster than their manufacturing counterparts in recent months.

Still, if China remains a global concern, none of that will matter and it will still weigh heavy on the Fed’s next decision.

Low Inflation

One key economic variable that has kept the Fed from raising rates (and one discussed at length by Yellen last week), is the low rate of inflation.  Her comments on why she/the Fed thinks inflation in the U.S. remains low was quite interesting … not to mention practical.  She feels that the steep drop in energy prices this year has lowered inflation by roughly 0.75 percentage points from the Fed’s 2% goal … Oh, I just filled up with diesel at $2.30 this morning in an SUV that gets 28 MPG without any Volkswagen cheater software.  On top of that, the decline in import prices (thanks largely to the rising dollar) has lowered inflation by over 0.50 percentage points.

So What About The U.S.?

Last week we found out that the U.S. economy expanded at a 3.9% rate in the second quarter, which is better than expected thanks to a stronger consumer and construction spending.  Second-quarter growth has been upwardly revised twice following the initial 2.3% estimate, and far exceeds the 0.6% growth in the first quarter. Economists expect third-quarter growth to be slightly above 2%. I wrote this (below) back in May about first and second quarter GDP:

“Warning – 1Q Gross Domestic Product may be revised lower and may even come in negative for the 1Q as the first revision is reported this week. Recall from a previous blog where I wrote about the recent GDP report that Q1 Gross Domestic Product grew just 0.2% on an annualized basis. This past week I started to see a lot of economists predicting a revision to show the economy actually contracted in Q1…meaning GDP could ultimately be a negative number for the 1Q 2015. These predictions could be due to some economic data that is signaling the economy has not gained much steam; indications include:

1. Poor consumer spending due to a cold winter

2. Muted exports because of a strike in a west coast shipping port

3. Declining oil prices

4. Poor manufacturing data

We think this is all behind us. As we look into 2Q 2015, we are already seeing improvement. In fact, I was just reading the recent report on Leading Economic Indicators that showed it improved at a rate a faster than any other of the previous 9 months.”

So, We Still Favor Equities … Even As They Are Getting Crushed.

I suspect U.S. equities will struggle until China’s economy stabilizes and the Fed starts raising rates. Rays of light are the strong jobless claims, really poor sentiment levels (meaning investors are not wildly optimistic and piling into stocks), housing and autos.  We mentioned housing and autos in our Mid-Year Review Videos, but these are highly cyclical sectors, labor-intensive and respond to consumers’ ability to borrow (they have good credit and low debt) and pay (wages growth).  Normally, highly cyclical sectors grow way faster than GDP but in this current recovery/expansion, we have not really seen that in either housing or autos.  They are growing – pretty nicely in fact – but not at a run-away pace.

The upshot? I think we are a long way away from an “overheated” economy.  Stay long equities even if it hurts.  It’s like exercise, and takes a while to see results … and if you eat a whole pint of Ben & Jerry’s Ice Cream by yourself you have to keep at it a little longer.

P.S. I have never done that … ever.  I swear.  Not once.

Call with questions or concerns.

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