Our CEO, Jack Rivkin, recently revisited his thus far prescient view of economic issues facing “The Rest of the Americas.” There are several key drivers one should pay attention to when evaluating the Americas, most of which ultimately lead to the commodity markets.
From the Fed’s decision on interest rates (which is highly data dependent), currencies, the dependence of Chinese demand for commodity exports out of Canada and Latin American countries, and nearly ubiquitous political disharmony, commodities are at an inflection point. Here is why:
US Economic Data and the Fed
April retail sales were up 1.3%. Job creation is improving and wages are starting to improve as well. Economic data is getting better, but it’s not necessarily good enough for the Fed to take action. What are the possible scenarios and impacts on commodities?
- Good Data: If we continue to see decent economic data, it could spur the Fed to raise interest rates at the upcoming meeting in June. An increase in the Fed Funds rate generally leads to strength in the US dollar (USD) relative to other currencies. Conventional wisdom stipulates that a strong USD is typically a negative for commodity markets; the two are negatively correlated since commodities are priced in USD. If the USD strengthens, commodities tend to suffer because it will take more dollars to buy the commodities. While that’s been true the majority of the time, it’s not always the case as one can see below:
- Great Data: That said, if the data out of the US is very positive—one could view this as a growth theme. In this case, the Fed will almost definitely raise rates in June; the USD will rise; but if the US is consuming more, spending more, and on an improved economic growth trajectory, that could spur increased demand, which could actually push commodity prices higher.
- Bad Data: The last scenario is if the US data gets worse. We don’t think this is all that likely, but low inflation could make the Fed blink. Where we may see bad data is globally. With global markets more intertwined than ever, it would be bold for the Fed to ignore any further and significant global weakness. Moreover, the big Brexit vote shortly after the June Fed meeting could give Yellen pause, ultimately postponing a hike until July.
According to both the World Economic Forum and the Wall Street Journal (WSJ), in 2015, China consumed “roughly an eighth of the world’s oil, a quarter of its gold, almost a third of its cotton and up to a half of all the major base metals.” In addition, as Jack pointed out in his Perspectives piece, China also produces about half the major base metals. One cannot discuss commodities without discussing China.
All eyes are on Chinese growth to continue fueling this impressive demand. Chinese growth is less than it was in prior years but their growth target remains between 6.5%-7.5%. While momentum has slowed, 6.5%-7.5% is not insignificant. To give some obvious context, the U.S. economy grew 0.5% on an annualized basis for the first quarter of 2016.
As Chinese demand for and production of commodities vacillates and its growth moderates, we could see more idiosyncratic Chinese market movements. For example, during September of 2015, China’s National Administration provided new standards for the use of aluminum cables. Aluminum is significantly cheaper than copper and China is rich in aluminum resources—substituting aluminum for copper allows for lower costs and less importing. Prior to September of last year, copper and aluminum prices moved fairly closely together. Since this time, however, we’ve seen more dispersion, periods in which aluminum rallied and copper declined. Thus demand may be increasing right now for base metals, but one may continue to see more substitution versus base metals moving in concert.
The remainder of 2016 should be interesting. If China backs off stimulus or increases local production, it could spell trouble for commodities given their significant share of commodity consumption. We tend to agree with the team from Gavekal Research, who recently stated the following:
“Since GDP growth in 1Q16 remained above the 6.5% target, it seems likely
—Gavekal Research, Chen Long, The Daily—“No More Easing Likely,” May 15, 2016;
If this is true, we may not see more stimulus from the Chinese central bank. Yet, a complete economic slowdown followed by stunted commodity demand seems unlikely.
With the exception of Trudeau’s white knight status in Canada, much of the rest of the Americas’ leadership remains on shaky ground. Democracy in its raw form is coming to the USA, Rouseff is on her way out of Brazil, while Mauricio Macri is still sorting out the pieces in Argentina—and he’ll be doing that for a long time. Any perceived weakness in leadership could be viewed by investors as a sign of a weak economy. This too matters because as faith in these governments declines, so may their currency as we witnessed several times last year. For example, one of Brazil’s largest exports is coffee. A weak Brazilian real led to lower coffee prices. In fleeting moments of real strength, coffee rallied alongside.
For countries that rely heavily on commodities for exports, a weak currency is not necessarily a positive. Therefore the impact of political unrest on commodities could make for a bumpy ride, at least in the short-term.
One may ask, is this a good time to get into commodities? The reality is, it depends on what sector, what commodity, and when. The question also assumes that investors only have the option to go long commodities. Imagine if you could have been short crude oil over the last two years? Our preference is to invest in strategies that can go long and short, such as trend following managed futures strategies. These strategies are systematic in nature with the goal of following price trends. If gold continues to rally, trend following systems will likely add more and more long gold exposure. In fact, most managers we follow are positioned long after gold’s rally this year. If the trend abates, these systems will typically reduce exposure and if the trend reverses strongly, these systems will follow the price trend in the other direction. Investing in systematic trend following strategies allows for long and short investing while taking out the discretionary judgement of trying to time these often volatile markets.
Commodities are indeed at a crossroads with some dispersion likely. Much of what can move individual commodity markets for the remainder of 2016 remains to be seen, as various other cross currents make it difficult to predict. In other words, even if we get Fed clarity, China and other variables could remain uncertain. Investors may want to look for trend following managed futures strategies that have the ability to follow commodity markets directionally once the fog clears.
We are continuing our review of what has happened since we laid out our expectations in our Perspectives at the beginning of the year. We had a view that one could find all manner of investment opportunities, long and short, without moving beyond the continents of the Americas. Given the volatility of the markets and the currency and commodity movements since then it is time to take a fresh look—particularly at the rest of the Americas. Below is a reprise of our expectations and our update of how the expectations have changed. Commodity and Currency movements as well as specific governance issues may cause a greater dispersion in results for the rest of the year.
CIO PERSPECTIVES RECAP: JAN 2016
The Rest of the Americas: Still some Economic Issues but an Improving Picture as One Moves from North to South
Canada, in many ways, is a large natural resource company. Until the energy picture improves, there remain issues as a new and different government starts to grapple with the current environment. In addition, while the Canadian banks avoided much of the turbulence experienced in the US from the mortgage fiascos, their housing market has gotten somewhat extended from growth that occurred under the umbrella of high energy prices in the early part of this decade.
On the other hand, we see elements of reform and a better competitive environment globally in Mexico. Lower energy prices have slowed development and reform in this sector, but other sectors continue to move forward. This remains a good story of growth, reform and development.
Moving further south, if the project stays on schedule, by mid-year the expanded Panama Canal should be in operation with the ability to receive the Post-Panamax cargo ships that carry two to three times the previous loads that could make it through the canal. This will change patterns of traffic to the east and west coast ports of the US from East Asia, reduce transportation costs, and, most likely, produce a shift of traffic via the Suez Canal back to Panama. It could likely result in some increased infrastructure spending for some of the US ports as well as the supporting rail and truck traffic from these new patterns of shipping. An under-the-radar change that could have some unintended consequences positive and negative.
With the Argentina election leading to major change combined with elections in Venezuela and pressure on Brazil to change, the center of gravity on reform and a better investment environment in South America may be moving in the right direction. There is no question that the overall economic situation in South America is quite dependent on exports of hard and soft commodities. Until the commodity supply/demand picture improves, it may be difficult for the overall investment environment to improve significantly. We may be entering an environment where some prices are falling below operating breakeven. Let’s keep in mind, though, that energy is a big part of the cost of extraction and refining for most hard commodities. Miners and refiners will keep producing if there is a dollar contribution toward fixed costs. With the metals priced in dollars for the most part, the currency weakness many of these countries have seen is a further reduction in costs. It is possible as we get later into the year modest increases in demand combined with reductions in supply may shift the patterns. At the same time, it is highly unlikely that we will see major improvements in governance and economic results early in the year in these three countries mentioned. However, the tone has shifted. This is an opportunity for the US to affect the rate and quality of change in these three important South American countries with an impact on the whole continent.
While the change in our relations with Cuba gets media attention, a similar reaching out by the current administration to change relationships with the three countries is a real possibility. One will be able to find all of the varieties of investment opportunities within the Americas with similar risk characteristics as exist throughout the rest of the world. This is a slight overstatement, of course, but just saying…
One does have to be careful of what is going on with capital flows. The countries in South America are dependent on export growth primarily tied to commodities. While Argentina may be coming out the other side of its ability to access the capital markets, it is not clear that other countries can make it through this period without some degree of financial stress. But, the Americas represent an unusual somewhat isolated set of investment opportunities across the equity, fixed income, and fixed asset markets, both public and private.
TODAY: MAY 2016
Commodity Movements push much of the Americas to Unsustainable Levels—too Fast, too Soon
Below are three bar charts showing returns in local currency and dollar-based YTD for most of the capital markets worldwide as well as a specific focus on the Americas and commodities.
In part, the commodity run has to do with the weakness of the dollar against many currencies. Gold and possibly other precious metals are primarily moving because of the dollar, but also because they can act as sources of real returns against an expectation of rising inflation, low interest rates, and, maybe low equity returns. Our expectation had been a likely shift occurring on the commodity front as we moved into the second half of the year. In part, this was based on a step-up by China on the fiscal side which would increase demand and prices for a variety of commodities as infrastructure and support of inventory building took place. It would appear that China has already started that process. Unfortunately, I think this could lead to some disappointment later as China backs away from this fiscal push, much as they did after the 2008-2009 debacle. China did keep things going with prices peaking in 2011. There has been some slowdown on the supply front, with much uncertainty about OPEC and Saudi Arabia, specifically regarding oil, but other supply slowdowns elsewhere including the fires that rage in the Canadian oil sands region. Of course, the rise in prices could reflect concern about the Cushing Fault—one of our cocktail conversation expectations. Even 60 Minutes is now talking about earthquakes in Oklahoma.
That aside, as we pointed out in our Perspectives piece, China is the biggest source of supply and demand in the hard commodities, and effectively, controls the markets. Higher prices may lead to bad economic decisions regarding maintaining or even increasing production in response to the prices. These increases will likely end when China stops supporting the price and/or the dollar begins strengthening as it becomes clearer that a recession is unlikely—slow growth, but growth, wage increases and hiring pushing up consumption but not necessarily profits. Last month, for example, total compensation for all those employed was actually up 0.7% March to April. That’s a pretty healthy annual rate.
So what does one do now? The Americas look a bit ahead of themselves. While we are seeing change in Latin America, there will be some major hurdles for the major countries on governance and fiscal budgets. Commodity prices could continue to provide a lift if what is going on in China continues. I think we will start seeing more dispersion in the results in Latin America as the year unfolds.
We have already indicated that we expect the slower growth of the global economy to produce dispersion among country and company results. Below are two tables that show what has happened in the US specifically by industry with the energy industry as a poster child.
This does require a broader and more specific look across more asset classes and more managers to take advantage of the dispersion and the spread we could likely see between the liquid markets and those with an ability to buy into less liquid sectors. The opportunity set is getting broader and requiring a real understanding of risk and a real understanding of liquidity requirements.
Lastly, so much of what I discussed depends on what happens here in the US as well. As my colleague, Lara Magnusen, recently pointed out in Bloomberg, any positive economic data out of the US may convince investors that the Fed will indeed raise rates at their next meeting. The knock on effect here is that you could see some real strength in the dollar, and thus reversals in commodity markets generally. The rest of the Americas are thus dependent on a highly correlated set of variables affecting commodity markets, and, ultimately, the broader economic landscape.
High yield debt sure does look scary today. After recording its worst annual performance in a non-recession year during 2015, it realized another milestone earlier this year. The asset class, as measured by the Barclays US High Yield Index, reached its third largest drawdown in history, matching its performance during the 2001-2002 recession. Only the losses in 2008 and 1990 have been larger when compared to the recent period.
Given the steep declines, should investors brace themselves for further losses and liquidate their high yield portfolio en masse? In short, we think not. In fact, we believe this is the best time since early 2009 to be a selective investor in short-duration high yield bonds. Prices have overshot fundamentals in most sectors, and it is precisely these overreactions that sow the seeds for the potential to outperform in the future.
Three key reasons underpin our view:
- This is not 2008
Nearly a decade after the financial crisis, the scars of 2008 remain fresh in investors’ minds. Fears of another crisis have led many investors to run for the exits with little regard for fundamentals. The fact that high yield recently matched its third largest drawdown in history despite any hint of recession or material change to the default rate environment underscores today’s disconnect between prices and fundamentals. Moreover, the conditions that drove the 2008 crisis—highly leveraged financial institutions and a faltering economy—are not present today.
Financial regulation has resulted in much stronger balance sheets across the financial system, and we believe the risk of a recession is low as job growth continues apace and the services sector—which accounts for 80% of the US economy—has been growing solidly.
- Current yields compensate the patient investor, even if spreads widen further
For the first time in several years, the math of owning high yield bonds is strongly in the investor’s favor. Why? Both spreads and current yields have increased to multi-year highs and adequately compensate investors to take credit risk at today’s price levels. Annual coupon payments now average nearly 8% at the index level, and bond prices have declined from over par in mid-2015 to 85 in early 2016.
Investors now have the potential for both income generation and capital appreciation over the coming year for the first time since 2011. In the event that the “risk-off” sentiment continues over the near-term and credit spreads widen another 2%, investors could still realize positive returns over the next year based on today’s yield levels, and that may help to provide a relative cushion in the event that prices continue to decline.
 Source: Barclays
- Look beyond the indices
As we enter the late stages of the credit cycle, sector and security selection now take center stage. In today’s market environment, avoiding the losers is paramount to picking the winners. Index investors are likely at a disadvantage because they assume concentrated exposures to the sectors that have issued the most debt—telecom in 2000 and energy in more recent years, for example—which may be a formula for future underperformance.
Investors that take an active, security-focused approach with a sharp focus on sector and company-specific fundamentals have the ability to identify idiosyncratic risks and opportunities—and therefore may benefit from the price noise—in what is likely to be an increasingly unstable environment ahead.
While caution is needed in this volatile environment, we believe there are outstanding risk-adjusted investment opportunities present in today’s markets. Why now, and not after default rates have spiked? Investors should note the cautionary tale of 2009: default rates peaked at 10.3%, while the ML High Yield Index returned 57.5% that year and 15.2% in 2010. So instead of waiting for the “all clear” signal—which may likely coincide with lower potential returns—investors that have been underweight high yield debt should consider increasing their allocations to the sector today.
It’s still a slow growth environment. Inflation is low. Investors can expect continued performance dispersion.
Employment is off the table for the Fed
As mentioned in our earlier video blog the November employment gain of 211,000 combined with the upward revisions totaling 35,000 for September and October certainly took the employment issue off the table as a showstopper for a Fed Funds target rate hike this month. There are very few categories where the actual unemployment rate is above the 5.0% rate for the overall workforce: teenagers at 15.7%, blacks at 9.4%, Hispanics at 6.4%, those with less than a high school diploma at 6.9%, those with only a high school diploma at 5.4%, and I would highlight mining at 8.5% (versus 2.8% a year ago). I would posit that these levels are not the responsibility of the Federal Reserve to deal with. And, what is going on in the mining sector, which includes oil and gas extraction, may have added to the employment roles in other categories as lower energy prices increased both consumption and most companies’ (ex-energy’s) profit margins. The November beige book and the latest JOLTS report point to a tighter labor market with increased difficulty filling jobs and quit rates high, which point toward an increase in wage rates. The Fed does have to look at a tight labor market and make some judgments regarding this ultimate impact on inflation and the pace at which its 2% target is achieved.
So what about inflation?
The Fed’s preferred measure of inflation is the core personal consumption expenditure (PCE) index. That index is up only 1.3% year-over-year and was actually flat month-over-month in October. The general belief is that the US inflation rate may stay lower longer given the expected slow pace of global economic growth, the strong dollar and continued technological innovation. One cannot ignore the tragic events in Paris and San Bernardino as having an impact—on the margin, of patterns of consumer spending and, possibly, levels. This is likely to keep the Fed on a very slow path of target rate increases extending the runway for slow but steady real and nominal growth. I think this path will be followed until inflation actually picks up. I have some views on the timing of this, which I have been saving for this year’s Perspectives piece “What to Expect in 2016 (and Beyond),” but will provide a preview in a separate blog as a wild card to watch for.
And what about the markets?
In turn, these economic and financial results will likely produce slow growth–matching nominal GDP–in the US stock market if valuations stay close to current levels.
The fixed income markets, on the surface, could also appear somewhat benign with a moderate increase in overall rates. No doubt, the slower pace of growth will produce specific credit issues—certainly in energy, but likely some other entities—but credit overall, may hold up reasonably well. The credit markets, at the moment, would appear to be pricing a broader disaster, particularly in the high yield markets. I think we will see some specific disasters—credit issues, but decent credit analysis can eliminate or reduce the impact. An actively managed portfolio in high yield could be a logical allocation to a portfolio.
Odds are some of the longer term trends in currency, commodities, and relative market performance will continue for awhile with some bumps along the way when markets misread central bank actions or statements (à la Draghi) or geopolitical events cause temporary disruptions.
So, how should one invest?
In the table below, which looks at performance of the S&P500 over the last several years, an interesting pattern emerges:
When the market has been up or down double digits all one really had to do was either own or sell the whole market. However, when we have experienced single digit performance for the overall market, much as we are seeing this year, there has been significantly greater dispersion among stocks. This is an environment we expect to continue for some time—slow nominal growth in the economy and the equity markets, leading to dispersion of performance tied to active company management and active investment management. Why do we expect slow nominal growth to persist for several years making active management more important? There are at least four reasons (and I am sure some others):
- As Eric Peters of One River Asset Management recently reminded us, when the Fed takes action, which is typically designed to reduce the magnitude of an economic decline or surge, it has an effect on future patterns of growth. Easing pulls growth forward, while tightening pushes growth out, reducing the depth of the valleys and the height of the peaks and the distortions in employment and inflation those produce. We have been through an extraordinary pulling forward of future growth and it will take time for us to return to normal.
- The debt burden incurred by sovereign nations has been and continues to be enormous. If nothing else this will affect fiscal policy as the tool it could be to add to growth opportunities.
- China’s transition from a global engine for industrial production and consumption to a more internally focused services economy, combined with the reversal of its own extraordinary steps to offset the impact of the western world recession—just look at the production and pricing of hard commodities beginning in 2009—will be a damper on global growth for the foreseeable future. This bears watching to see how closely the yuan continues to track the dollar, or if its inclusion by the IMF as a reserve currency leads to a tracking of a basket of currencies and a different interest rate regime.
- Without putting too much weight on it, the “Buffett Rule”—future equity growth is problematic for a number of years when the total market value of equities exceeds the value of GDP—is operative. I discussed this anecdotally in a recent post.
In a slower growth environment the likely dispersion of equity returns would push one away from index-hugging strategies toward active managers both long only and long/short managers. We have been suggesting this for a while. We would include private equity allocations in the active long only category if immediate liquidity is less of a need and the attractiveness of a potential illiquidity premium in a lower growth environment is magnified. We have these more active managers in our stable of funds, but others do as well. The key message is to adjust allocations to include more of these active strategies in the portfolio as one looks at the environment ahead.
In the fixed income space, while there is risk of rate volatility affecting all debt classes, as big a risk would appear to be more specific credit issues. Does that mean one should be moving up the credit curve? I think the answer is in part, “yes.” But, the preferred way to do that would be similar to the approach on equities: Look for active managers—not benchmark huggers—who are analyzing specific credits and taking advantage of the homogenization of yields that comes from index buying and selling. The high yield index is offering a fairly significant yield spread over treasuries—very tempting as a category. But, just remember that around 18% of that index is in energy and hard commodity bonds. As shown below, the rest of the index, while at lower yields, is at spreads we haven’t seen for almost three and a half years. Historically, in a different energy regime, the rest of the index used to trade at higher spreads than oil and metals.
At this stage, I would rather have someone looking at individual securities making up a diversified portfolio where the detailed analyses show relatively lower credit risks in the environment we foresee. Who knows? There may even be some energy credits that are worth holding but have been tarred by association. We see that in our own portfolios. There are certainly some credits in both high yield and investment grade where the credit default swaps don’t fully reflect the degree of risk at this stage. I want managers who are running portfolios where they can tell me the precise nature of the balance sheets of their individual holdings and the risks associated with the businesses. This is different from what has been required previously.
One should not ignore the uncorrelated strategies, particularly systematic trend following. There are some long-term trends in place. While there are likely to be occasional reversals—some of which could turn into more permanent moves, I would rather use these managers to recognize the patterns and determine which foreign exchange, commodity, equity and fixed income indices should be included, negatively or positively, in the portfolio at any given moment in time given the environment we are facing.
Allocations need to change
It is hard to determine in isolation what the allocations in a specific portfolio should be. That requires a discussion. I know the allocations to active strategies should be higher. As I have been saying, past performance may not be the best guide for the future as opposed to a realization of a different pattern of future returns and an understanding of the volatilities and risks that exist in the environment we foresee. It is a less easy environment, with lower overall returns, but possibly a broader set of opportunities to meet one’s specific goals.
How to make money when your refrigerator orders milk
The U.S. Department of Transportation (DOT) wants cars to talk to nearby cars to aid in safety and maybe target traffic congestion. According to DOT, there are more than 255 million registered vehicles in the U.S.[i] – that’s a lot! Meanwhile, in the air, a single Boeing Dreamliner tracking its flight creates enough data (40TB[ii]) per hour to fill about 57,000 CDs[iii]. On my wrist, my Nike Fuel Band talks to both my phone and laptop, and every piece of information that’s remotely relevant gets measured, transmitted and stored. In my kitchen, my smart refrigerator complains to my microwave that the embedded music system never plays Perry Como, because it’s fixated on Katy Perry.
As a real estate investor, my company AACA is drawn to stocks of companies that possess certain characteristics. We look for businesses that operate in sectors that have few competitors, where the real estate they own is in markets with very high barriers to entry, where the tenants have practical, locational, or physical issues that prevent them from moving, and lastly where the tenants or users are experiencing strong secular growth. In our opinion, data centers and cell phone tower operators fit the bill for these characteristics. I’m going to be speaking about this and more in an upcoming webinar on August 27th. I welcome you to attend (Register here).
What are data centers?
Data centers are giant high-tech facilities used to house computer systems and associated components such as telecommunications and data storage. They are ultra-secure buildings outfitted with redundant systems including power-supplies, security and communication systems, environmental controls, blast and EMP (electro-magnetic pulse) protection. These buildings use as much electricity as a small town. Perhaps you have seen data centers in the movies. Any good action hero – like Tom Cruise in Mission Impossible – invariably needs to retrieve a secret data file from one of these impossibly-complex-weapons-grade facilities at some point in the plot.
But in our opinion, “the Internet of Everything” is a massive secular demand driver for these companies. The possibilities are nearly endless. Some are trivial, such as my Nike Fuel Band or my refrigerator telling me I am out of soy milk (don’t even ask) and some are crucial, like medical devices chatting with one another to update the health status of a nursing home population or hospital. Soon wearable computing is likely to be as ubiquitous as cell phones are today and the sheer amount of data these items will gather, store, share and access boggles the mind.
Accelerated demand for data storage
Perhaps you have heard the saying that 90%[iv] of the world’s data was created in the past 2 years. Activities that previously were non-data producing, like hailing a cab (UBER) and dating (eHarmony), are now at the center of the digital revolution. All this data has to be stored somewhere and the demand is growing. Morgan Stanley says the number of devices connected to the internet will exceed 75 billion[v] by the year 2020 – that’s about 10 connected devices per person for every man, woman, and child. We believe this is a long-term trend that may make for a good long-term investment.
If you take this to its logical conclusion, huge quantities of currently inert non-connected items will start connecting, talking, communicating, and eating up bandwidth. As more and more people connect and create data, all these products will need to store data in the cloud, housed physically in data centers and will need to transmit that information via cell phone towers and other wireless networks. Cisco’s expectation for wireless bandwidth is that global mobile traffic will grow almost 10 fold between 2014 and 2019[vi]. We like this.
Development yields vs. traditional real estate
Data center real estate investment trusts (REITs) develop and operate the buildings that house the cloud which can potentially generate compelling profits. Due in part to the surging demand and lack of supply (these buildings are very difficult – nearly impossible – to build), data center returns and development yields have been different than the returns of more generic real estate sectors.
While growth in this sector is in some way a blinding glimpse of the obvious, we don’t think it’s actually baked into the numbers. Each time available bandwidth has increased, previously unimagined applications pop up to absorb that bandwidth and store that information. No one would have predicted 5 years ago that kids would have Facebook’s mobile app open on a smartphone 24 hours a day running in the background.
There is a lot of research that needs to go into understanding the sector, which represents a small part of real estate overall. We are seeing an overwhelming secular demand in data centers and cell phone towers, and continue to actively manage our exposure to the sector. If you’ve ever wondered how to allocate real estate in your portfolio, you can download our recent whitepaper (here) on real estate in Modern Portfolio Theory.
To hear more from Burl East, Register here for the webinar on August 27th, 2015.
[i] Source: U.S. Bureau of Transportation Statistics https://en.wikipedia.org/wiki/Passenger_vehicles_in_the_United_States#Total_number_of_vehicles)
[iii] assumes 700MB size CDs (40TB/700MB = 57,143)
[iv] Source Science Daily http://www.sciencedaily.com/releases/2013/05/130522085217.htm
[v] Source Morgan Stanley http://www.businessinsider.com/75-billion-devices-will-be-connected-to-the-internet-by-2020-2013-10
We still believe the employment numbers, as reflected in the monthly BLS release and the JOLTS reports, are among the more significant factors in the timing and pace of a Fed decision on raising rates. However, the weakening of the yuan in the short term has overwhelmed other factors affecting the global economy and central bank decisions—at least in the minds’ of the media. There are other factors that come into play as well, including the actual pace of both US and global economic growth, productivity, and commodity prices. Let’s try to put these in perspective.
The Labor Department reported employment increased by 215,000 jobs in July. This seasonally adjusted number was close to consensus, and kept the unemployment rate at 5.3%. While we expected the rate to remain unchanged, 215,000 was below our expectations. July is typically a layoff month as one can see in the tables below comparing seasonally adjusted results with the unadjusted numbers.
Factories often close down for maintenance, the educational systems close down for the summer, and many service organizations adjust to different patterns of activity for the summer months. Based on the unemployment claims and other evidence that companies were having a hard time finding qualified workers, thus holding onto employees, our expectation was for a larger seasonally adjusted number. We will see what the next two revisions bring. Note that last year in July, the unadjusted number, which was a bigger loss than this year, ultimately resulted in a significantly higher seasonally adjusted number. In the meantime, the workweek was up 2.7% over a year ago, and hourly wages were up 2.1%. That puts weekly wages up 4.9% from last year. July is a strange month because of the seasonal adjustments required to make a negative number into a positive number. This has to be a tough month for the BLS to estimate. This is a number the Fed can interpret any way it wants to.
China’s “floating” of the yuan (renminbi) and the subsequent weakening of the currency have added new elements to the view of growth in China and the state of currency relationships, particularly in the emerging markets. It has put additional pressure on hard commodity prices and raised issues around the time it would take for central bank inflation targets to be met. The timing of the move was interesting. Clearly, it is to China’s benefit to have a weaker currency in terms of its export markets. On the other hand, it does raise import prices and has an impact on both the Chinese consumer and company profit margins. As significantly, a freer floating renminbi is consistent with the desires of the IMF in considering the renminbi as a reserve currency. It is our view that while growth is slower in China, it is likely faster than growth in most of the developed world. It is not clear that a freer floating renminbi would produce a major weakening once the speculators are removed from the picture. This will bear watching—particularly as it relates to China’s economic growth. Let’s understand that, while the focus is on China’s major slowdown in industrial growth, services—which are more internally relevant—now represents close to 50% of the economy and continues to grow. I would urge readers to take a look at the recent macro outlook webinar we did with Henry McVey and Dave McNellis of KKR where China growth was discussed.
The Fed and Interest Rates
The Fed will have one more look at the employment numbers before its meeting on September 17. This will include the JOLTS report for July as well as the August employment numbers and revisions to earlier months. If these numbers are, at worst, neutral, odds are the Fed will start down the path of raising the Funds rate. Let’s also understand that the effective Funds rate will be the rate at which banks lend to each other to meet reserve requirements. For example, the Fed could raise the targeted Funds rate by 25 basis points, but the rate at which banks are prepared to borrow or lend could vary. We are entering an unusual period where results may be inconsistent with history, regardless of the timing of Fed rate increases. Odds are, once the Fed actually does raise the target rate, we will start hearing more about the Reverse Repurchase facility that has been set up to provide better control of the actual rate. All of this depends on what other data we see on the US and global economies. How much attention will be paid to what is happening in the rest of the world remains to be seen. Our view is the US data will be the driver of timing for the Fed. And, our view, shared by others is that the Fed will begin the process sooner than the futures would indicate. Whenever the process starts, it will be a gradual undertaking with some elements of experimenting and observing the data before additional rate increases take place. Getting us to this point has been an experiment. This will continue as we work ourselves back to “normal.” Experiments can lead to accidents. The combination of the variable global economic picture, low oil prices and related low commodity prices in general, systemic foreign exchange fluctuations, high valuations, low top-line revenue growth, and some wage pressure, will lead to larger variations in performance geographically, by sector and by individual company. It is a time to Pay Attention to more active managers on both the equity and fixed income side of the markets. Not only would I be looking for managers with lower correlations to the patterns we have seen in the last several years, I would also look for managers who can offer a measure of downside protection against the accidents we may see.