Near-Term U.S. economic growth expectations stand at a modest 2-3%, likely due to low labor participation.
The Fed remains eager to normalize monetary policy, yet has not taken steps to re-enter a normal interest rate environment.
All in all, the second quarter was boring and an opportune time to shine as an active equity manager.
No, I am not talking about the recent traffic jam caused by geese crossing Philadelphia’s Schuylkill Expressway, but rather the rubbernecking associated with Greece crossing the Germans. In no way, am I professing to have forecast the contractual resolution of the most recent Greek crisis. Instead, I am arguing that due to the relative size of either the Greek economy or its debt outstanding to European or global GDP, the likely outcomes were not going to cause a meaningful change in the net present value of future cash flows for the vast majority of companies in our portfolios. Nearly resolved, in our view traffic should now flow normally as investors re-focus on future inflation, interest rates, earnings growth and relative prices. Speaking of normal, U.S. near-term economic growth expectations are locked in at a tame 2 to 3% growth rate. Moreover, non-threatening wage growth is just 2% despite joblessness at the lowest level in seven years at 5.3%.1 A low labor participation rate must be the culprit. Now, at the lowest rate since October 1977, low labor participation acts as a pent-up supply ceiling to wage growth. It’s a little bit of a catch-22. Higher wages would likely seduce more workers into the workforce, yet the excess supply of ready participants acts as a lid to those higher prices.
Traffic Lights and Stop Signs
In their public comments, U.S. Fed policy makers remain eagerly poised to “normalize” monetary policy by raising short term-interest rates from their current negative real rate to the typical neutral or positive real rate history. By removing traffic lights and stop signs, motorist speed surely accelerated. Asset prices generally rose, most leveraged balance sheets were healed and investors were encouraged to invest. During the credit crisis of 2008 to 2009, this strategy worked famously. Strangely, the Fed has been very slow (read reluctant) to normalize (read tighten) policy. It took five years of rising equity prices before the Fed first began tapering the size of the Quantitative Easing it initiated in 2009. Now five years into the economic recovery – with unemployment at a cyclical low and little signs of recession on the horizon – the Fed should be ready to take the next step. Dual mandate accomplished – full employment and contained inflation! Does the Fed have a fear of failure or a fear of change? In either case, I think normalization is safer and will ultimately cause fewer accidents. Like stop signs and traffic lights, a normal interest rate environment (short rates in excess of the inflation rate) causes investors to pause and consider the risk of reckless investing. Normalizing policy sooner rather than later, in our opinion, will slowly reduce the size of the Fed’s balance sheet, enhance growth and provide more flexibility for future monetary expansionary policies. Or, maybe I am wrong – the Fed can have a balance sheet of infinite size for an infinite period.
Confined to just one lane, broad-based measures of U.S. equity returns were between plus and minus 1% for the second quarter of 2015. Regardless of size, equity performance remained within a 2% cattle chute. Mixed economic news throughout the quarter – ie, strong housing offset weak personal spending and retail sales, steady 2% wage inflation and less volatile energy prices all served to provide little incentive for big moves here. Even international equity indices like the EAFE and All Country ex-U.S. Index were little changed for the quarter – despite a bear market decline in China. The data dependent Fed policy would thus be little changed and there were no material measures in fiscal or tax policy to create overall volatility. All in all, the second quarter was boring and an opportune time to shine as an active equity manager.
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