Jul 28, 2015

Dark Clouds Clearing

At the beginning of the year I had a rosy view of how 2015 would play out:

1.  The United States economy would grow close to 3% and the unemployment rate would drop below 5%.

2.  The Standard & Poor’s 500 would rise more than 10% by Christmas.

3.  With some monetary and fiscal help, Europe and Japan would grow more than 1%.

4.  After turbulent negotiations, Greece would stay in the European Union and maintain the euro as its currency.

5.  There would be a deal with Iran on its nuclear development program that would be both credible and enforceable but nobody would like it.

6.  The Chinese economy would slow and the stock market there would be dangerously overvalued, but while China would not be the engine of growth it had been for the past decade, its reduced pace would not destabilize the world economies.

Then, as we entered the second half of the year, each aspect of this outlook began to run into trouble.

We are at a point when various macroeconomic events could have a significant impact on the financial markets.  Here are my thoughts on recent events in Greece, the Iran negotiations, China and the United States.

I have a somewhat different view of the Greek situation from the consensus.  Most observers believe Alexis Tsipras was forced to give in on all of the demands of the International Monetary Fund, the European Central Bank and the European Commission and that he is in serious political trouble as a result.  My assessment of the situation is that, in the eleventh hour, Tsipras correctly concluded that Europe would, for a number of reasons, do almost anything to keep Greece in the European Union.  The first is the fear that there would be contagion in the southern-tier countries like Spain and Portugal, who might believe their economies would improve if they had control of their own currencies, and the European “project” would die.  The second is that a Greek default would destabilize the financial health of Europe generally, and the fragile economic recovery taking place there would be aborted.  In that circumstance, Tsipras would be forced to face the domestic consequences of default and withdrawal from the European Union and the euro.  Greece itself would be in revolutionary turmoil.  The banks would remain closed; pension beneficiaries, the military and public employees would be paid in scrip or IOUs.  The country would not have the funds to pay for gasoline and other imported goods.  Greece’s borders would become porous and Middle East immigrants would flood in through Turkey and elsewhere.  In the event of a default, it could potentially be persuaded to look toward Russia for support, despite currently being a member of NATO.

While Tsipras would appear to have capitulated on his anti-austerity program, he did keep Greece in the European Union, kept the euro as its currency and secured a third bailout of over $96 billion (a huge amount; more than 50% more than what was being discussed a few weeks ago) to reopen the banks and keep the country operating.  About half of this money will be used to meet external financial obligations.  Greece will also sell $55 billion in assets to repay loans.  The “No” vote on the referendum, which Tsipras encouraged, solidified his political position, so he should be able to withstand some of the criticism he will get by agreeing to the reforms.  His political party may be forced into a coalition and cabinet ministers may resign in protest, but he has guided his country through a terrifying economic storm and some collateral damage was to be expected.  There are many Tsipras critics who believe he could have achieved a better deal earlier, but I question whether the Greek people were desperate enough until now to agree to the harsh terms of creditors.  He has obtained what the Greek people wanted: money to move forward and continuing membership in the European Union with the euro as Greece’s currency.  The story is not over.  The Greek economy is in shambles and the prospect of running a budget surplus is dim.  While the current deal buys some time, we may be wringing our hands about Greece six months from now. 

I believe there will be a “best efforts” attempt to implement the reforms, but progress will be slow and the European review board will be tolerant because a crisis has been averted.  I doubt that Greece currently has the institutional structure to carry out all the required reforms, like tax collection and work rule changes.  Greece is not likely to be able to revise its pension program without provoking more public protests, and other austerity measures may hold back any recovery in the economy.  From an investment viewpoint, the temporary solution probably means that Europe will continue its modest recovery this year and that the dollar will strengthen.

In spite of the complexity of the issues, a deal with Greece resulted from two simple objectives: Europe’s intent to avoid a destabilizing default by a member of the Union and a desire by Greece to get a third bailout and keep the euro.  The Iran talks reached an agreement because of two similar controlling factors:

(i)  The international community wants to delay the Iranian nuclear development program as long as possible.

(ii)  While Iran has been able to “work around” its inability to import many critical goods, the sanctions still are hurting and the general population wants them lifted.  More than half its 78 million, largely educated, population is under 35 and is anxious to participate in the economic opportunities it sees elsewhere in the world.

As a result of these two factors, an agreement (not a treaty, which would have to be approved by the Senate) was signed.  Neither side will be fully satisfied (another similarity with the Greek situation) and the deal is unlikely to be viewed as a legacy achievement of the Obama presidency, but it will be judged as an accomplishment over the near term.  The agreement will not be considered a success unless the inspection provisions of the agreement are tough and that the sanctions are lifted slowly and only upon evidence that the nuclear development program has been restrained.   I think President Obama will veto any effort to block the agreement.  With sanctions phased out, Gross Domestic Product growth could increase from 3% to 6%, creating enormous investment opportunities.  Iran will begin to ship more crude oil (perhaps one million additional barrels a day), but I still expect somewhat higher prices for crude as the developed world economies recover.

In the case of China, any analysis needs to recognize that the country has only limited experience with capital markets.  The steps the leadership has taken to control the market decline may stabilize prices temporarily, without permitting the cleansing sell-off that could provide the ultimate low.  These actions include halting initial public offerings, stopping trading on half of the exchange-listed stocks, limiting the sale of stock by corporate executives and directors and controlling margin debt.  The market had risen 150% over the past year and has corrected only one third of that.  Price earnings ratios were at extreme levels, and are now at a more reasonable 20.  Accounting practices are questionable in many cases, and a number of indicators show that the economy was slowing.  A correction was to be expected, but that doesn’t mean a bear market has begun.  China is now the second largest economy in the world, and it is still growing more than twice as fast as the United States.  The key question, however, is whether the market decline will have an impact on the economy. 

In my view, the participants in the market were largely speculators.  The stock exchanges were mainland Macaus.  There were four million new accounts opened in each of the months immediately before the decline started and margin debt was at a record high, representing about one quarter of the peak value of the market; this margin debt has declined in line with the market correction.  The 90 million people who participated in the market represented 7% of the population.  While China has a high debt to gross domestic product ratio, it also has large foreign reserves and a powerful industrial base capable of generating a budget surplus.  I do not believe the decline in Chinese equities will destabilize financial markets even if it resumes, particularly given that the stock market plays a much smaller role there than in more mature western economies.  This will be critical given that China is still a key factor in the world economy, even if it may not be the engine of growth it once was. The fallout may be that China admits that the 7% growth that has been reported was too high and that 5% is more realistic.

In the U.S., the unemployment rate has dropped to 5.3%, but that is partly because of the decline in the participation rate.  Many people who were looking for a job may have become frustrated by their inability to find one and have dropped out of the work force.  Even though there are five million job openings, many companies have found that applicants lack the technical skills needed to perform the tasks required.  Although average hourly earnings have been increasing at a better than 2% rate, wages were flat in the recent monthly report, so incomes are not rising significantly.  Real earnings are still below where they were before the 2008-9 recession.  Recent retail sales reports have reflected this and been below estimated levels.  While household net worth is at an all-time high, most of that has been accumulated by those already in the top income brackets who own equities and expensive houses and have benefited from the appreciation of those assets.  They have a lower propensity to spend than those in the middle three quintiles of wealth accumulation.  I continue to believe a lack of demand is the biggest problem for the U.S. economy.

Housing and capital goods are two areas of the economy which I expected to be drivers of 2015 growth.  Housing starts are now running at an annual rate of over one million, and two factors that will influence the housing market are decidedly favorable.  Those factors are employment in the 25–34 age group and household formation.  I expect data on starts, new and existing home sales, mortgage applications and other housing-related factors to remain favorable for the rest of the year.

Capital spending is more problematic.  Operating rates are still below 80%, so there is plenty of spare capacity out there and limited need for new manufacturing plants.  Spending for labor-saving equipment has been strong, and this has enabled companies to provide goods and services with fewer workers.  The U.S. has a structural employment problem as a result, with many workers who have lost their jobs lacking the skills to find new ones.  This condition, coupled with the effects of globalization on the work force, is likely to worsen, creating both social and economic problems. 

After the 2008-9, recession many government entities reduced their spending, but now are contributing to the growth of the economy.  The federal budget deficit is running below 3%, so authorities are in a position to increase expenditures on infrastructure, job training and research and development.  The approval of these programs by a sharply polarized Congress is difficult to achieve.  As a result, the U.S. economy is likely to grow at a rate closer to 2% than 3% for the remainder of the year, but there is no recession in sight.  When the Federal Reserve starts raising interest rates, if it ever does, the increases will be small and intermittent.  Currently, we see little inflationary pressure.  I do not believe the market is overvalued.  At 2100, the Standard & Poor’s 500 is at 17.5 times $120 in estimated 2015 operating earnings, slightly above the long-term average.  Estimates for next year are $130, putting the multiple a little above 16.  I am still optimistic about the outlook for the U.S. equity market for the remainder of the year.

Taking all of the events of the past month together, many of the background conditions that had concerned investors, like Greece and the Iranian nuclear program, have turned favorable.  That should improve the outlook for equities in the other major markets around the world.

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