April 2015
Central banks are attempting to accelerate their countries’ economic growth rates by lowering interest rates and expanding money supply (printing money or easing bank restrictions). In the last quarter, China, India and Russia lowered interest rates. Australia lowered rates to a record low 2.25% while Denmark and Sweden lowered their overnight bank lending rates deeper into negative territory, -0.75 and -0.25%.
The European Union (EU), Japan and Sweden are now printing money to buy government bonds. This year the EU is expected to buy three times more bonds than the net government issuance, even buying bonds with a negative return (down to –0.2% annualized). These planned purchases helped drive European bond yields to record lows with some two and five-year bonds having negative yields.
In this era of low interest rates, many European banks are charging customers to deposit money. JP Morgan has announced similar charges to some of its US customers.
European and Japanese bond investors seeking positive returns have purchased some US bonds. Foreign demand has helped push the ten-year US Treasury yield below 2%.
These foreign bond flows can also make the US dollar stronger (vs. a weaker Euro and Yen). The dollar has risen about 25% and 20% against the Euro and Yen since last summer. In the last year US Treasury bonds have provided foreign investors with both a positive interest rate and a currency gain.
ECONOMIC OUTLOOK: SIGNALS REMAIN POSITIVE
The US dollar appreciation has coincided with the decline in many commodities, including oil. This should help developed countries and emerging Asian countries which are energy and commodity importers at the expense of Russia and many Latin American and Middle East nations.
While falling energy prices result in US energy sector job losses, the gain to consumers and other businesses is greater. Every penny drop in gas prices results in $1 billion per year of US consumer savings, which will likely be spent or saved elsewhere helping the economy.
Despite job losses in energy exploration, the US unemployment rate has fallen to 5.5% (vs. the 50-year average of 6.1%). The job market for skilled workers continues to tighten. Most new jobs being created today are full-time whereas they were part-time in 2009-2013.
Rising employment income and lower energy prices result in increased consumer spending and saving. When combined with increased bank lending, the outlook for the US economy remains bright despite short-term winter weather impacts.
FINANCIAL MARKET OUTLOOK: EVENTUAL INTEREST RATE HIKES
Near-term inflation concerns are subdued as commodity prices fall and a strong dollar lowers import prices. While these trends could last for most of this year, inflation concerns should return in 2016. Meanwhile, the tightening skilled labor force should result in higher wages.
Benign inflation and foreign bond buying have driven long bond rates back near record lows. US consumers can benefit from 30-year mortgage rates below 4%. Once a new house is purchased, funds tend to be spent on appliances, furniture and renovations. In turn, this leads to further economic growth.
Accelerating economic growth and declining unemployment will force the Federal Reserve to raise overnight interest rates above 0% later this year.
The Federal Reserve had kept interest rates at 0% for six years in order to let the US economy recover from the subprime credit crisis. This appears to have finally worked as some investors are buying subprime and Alt-A bonds again, now re-named “nonprime.” This may be a sign that the bond market is extended and interest rates are too low.
In the last six years, $1.2 trillion has flowed into bond funds. Some of this was from investors fearing stocks. Other funds came from savers who wanted more than 0% interest from money markets. As overnight interest rates rise and investor confidence returns, money may eventually leave bond funds causing long-term interest rates to increase and bond prices to fall.
FUTURE CHANGES: WHERE TO INVEST
Investors should assess how much risk they are willing to accept and be clear about their goals and constraints. Recurring cash income, growing wealth, capital preservation, time horizon, and volatility are key considerations.
In today’s low interest rate environment, it is difficult for bond investors to keep up with long-term inflation. Low interest rates do not compensate bond investors for some of the credit, currency and duration risk that is associated with many bonds.
Stocks continue to appear attractive over a long-term horizon, but remain volatile over short periods of time. Corporate profits will also be volatile this year as energy industry profits fall and many global companies realize slower sales and profit growth from a stronger dollar.
More conservative strategies like Growth & Income and Dividend Appreciation benefit from rising cash dividend streams. While recurring dividends can lower the volatility of a portfolio, these stocks don’t always keep up with hot stocks in a bull market.
Growth stocks and concentrated accounts can perform better in a strong stock market, but can also be more volatile over short periods of time. These portfolios also tend to produce a smaller cash income stream.
Cyclical companies can experience faster earnings growth as economic growth accelerates. These can include advertising, distribution, entertainment, financial service, industrial manufacturing, mobile communication, transaction processing and transportation firms.