January 2015

Central banks try to control monetary policy with the printing of money and movement of short-term interest rates. Switzerland recently joined Japan and the European Union (EU) in creating negative interest rates. In these regions, banks now charge depositors for holding their money. The Swiss, EU and Japanese central banks continue to print money to buy bonds.

As a percentage of the economy (GDP), the balance sheet of Japan’s central bank is now three times the size of the US Federal Reserve’s. Japan’s government recently announced a stimulus program and the EU is expected to announce a new debt buying program this winter.

In recent months China took several steps to increase its economic activity including approving $113 billion in infrastructure spending, injecting $144 billion into the banking system, loosening bank lending limits, and lowering interest rates for the first time in two years. The People’s Bank of China’s balance sheet is now larger than the US Federal Reserve’s.

Many economies dependent on oil exports have experienced pain as oil prices fell by more than 50% in just six months. Venezuela is in a depression and has a 64% annual inflation rate. As the Russian ruble fell by over 50% in six months its central bank raised overnight interest rates to 17%. Russia also spent $2.4 billion to save one of its largest banks. OPEC countries will feel varied amounts of pain as a $50 drop in crude prices can cost OPEC about $556 billion per year. As most Asian economies are net energy importers, OPEC’s loss is their gain.

ECONOMIC OUTLOOK: 5% US ECONOMIC GROWTH

In recent years concerns included political turmoil, currency debasement, sequester, debt ceiling, tapering and a stagnant economy. Today’s reality includes a strong dollar, a strengthening economy and tax and funding bills sailing through both the Congress and White House.

While there will still be headwinds from geopolitical turmoil, less competitive exports and lower capital spending on energy discovery, most of the domestic economy remains on the right track. Good economic news tends to be underreported, as riots receive higher ratings.

In the first 11 months of 2014 the US economy gained over 2.6 million jobs (a 15-year record).
If housing activity returns to normal levels in the years ahead, another 3 million jobs could be created.

In the last year the unemployment rate fell from 7.2% to 5.8% despite 416,000 more people participating in the labor pool. Five years ago, there were seven unemployed people for every job opening, now there are fewer than two. Today’s 5.8% unemployment rate is below the 50-year average of 6.1% and consumer sentiment is rising. The unemployment rate could be under 5% by year end. Wage increases should occur in coming years as there is a shorter supply of skilled workers.

The US reported domestic economic growth of 5% in the third quarter of 2014 following 4.6% in the second quarter. This is the first time in over 10 years that the economy has grown by over 4% for two consecutive quarters. As the consumer has more disposable income from lower gas prices and the economy has easy weather comparisons to last year’s snow barrage, strong economic statistics should continue in the months ahead.

FINANCIAL MARKET OUTLOOK: SIGNIFICANT SECTOR ROTATION

US overnight interest rates have been at zero, “a temporary emergency rate,” for over six years. This summer the Federal Reserve is expected to raise interest rates for the first time in nine years.

The Federal Reserve is expected to slowly raise interest rates during the second half of 2015 and into 2016 as the economy continues to grow and unemployment falls. Their goals include limiting inflation, including wage inflation.

Stated inflation should remain low in 2015 due to lower energy and commodity prices. The strong US dollar should also lower inflation from imports. As these trends annualize near the end of the year, reported inflation should start to accelerate.

During the year there could be great disparities of profit growth between economic sectors. Commodity and energy companies are hurt by lower product prices, and multi-national firms could be hurt by a stronger dollar and less competitive exports.

Many other firms should benefit from declining input costs as the prices of imports, raw materials and energy fall. However, some of these trends may end by next winter.

An increasing number of jobs and lower energy costs provide the consumer with more discretionary income. The average hourly paycheck is now the equivalent of 7.5 gallons of gas versus 4 just seven years ago. While it would be prudent to save some of this money or pay down debt, history suggests the average consumer will spend most excess funds. This activity should help boost sales and profit growth of more cyclical sectors.

FUTURE CHANGES: WHERE TO INVEST

As interest rates are at historic lows in parts of Europe and Japan, foreign bond buyers have been attracted to US bonds. This has kept US bond interest rates low. With rising overnight interest rates this summer and higher inflation by year end, bond interest rates could rise. In the meantime, today’s bond buyers have a hard time finding a return that exceeds long-term inflation.

While interest rates are below 5% and the economy continues to grow, stocks can provide more attractive returns than bonds. A focus on cyclical stocks that benefit from economic growth could lead to strong performance from some consumer discretionary, financial, industrial and technology stocks.

Long-term investors should make an allocation to growth stocks, as recurring sales, earnings and cash flow growth should be rewarded with higher valuations. Retired investors should consider stocks with rising dividends. During the last hundred years, dividend paying stocks outperformed the markets.

Happy New Year!