Tag Archives: global currency

Has U.S. Economy Slowed to a Standstill?

Increasingly, we live in a world of now. Instantaneous access to digital real-time data and news has simply become a given. You may be surprised to know that the Federal Reserve has taken notice.

To this point, GDP data from the U.S. Bureau of Economic Analysis (BEA) has arrived after the fact. From the perspective of a financial market and investors that are always looking ahead, GDP data is “yesterday’s news.” Moreover, revisions to GDP can come to us months or even years later, essentially becoming an afterthought for decision making.

Recently, though, the Atlanta Federal Reserve has developed what it terms a GDPNow model. It essentially mimics the methodology used by the BEA to estimate inflation-adjusted, or real, growth in the U.S. economy. The GDPNow forecast is constructed by aggregating statistical model forecasts of the 13 components that compose the BEA’s GDP calculation.

Private forecasters of GDP, such as the Blue Chip Consensus, use similar approaches. Their forecasts are usually updated monthly or quarterly, but many are not publicly available, and many do not specifically forecast the components of GDP. The Atlanta Fed GDPNow model circumvents these shortcomings, forming a relatively precise estimate of what the BEA will announce for the previous quarter’s GDP. The model is still young, but it is beginning to be discovered more widely among the analytical community.

The reason we highlight this new tool is that we’ve incorporated it into our continuing, top-down review of the U.S. economy. More important to our “here and now” thinking is the current reading of this new model. As you can see in the next chart, the forecast by the Atlanta Fed for Q1 2015 U.S. real GDP growth is 0.1%, up from 0% at the end of March. As is also clear from the chart, as of the end of the March, Blue Chip economists were collectively predicting 1.7% growth — quite a difference.

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Chart Source: Atlanta Federal Reserve

Why the drop in the Atlanta Fed real-time forecast for Q1 2015 real GDP? As we look at the underlying numbers in the model, we see recent weakness in personal consumption. Many had predicted an increase in consumption with lower gasoline prices, but that has not played out, at least not yet. Weakness in residential and non-residential construction has also played a part in the downward revision. Weather on the East Coast has not been kind to builders as of late, but that’s a seasonal issue easily overcome by sunshine. Importantly, slowing in U.S. exports and equipment orders meaningfully influenced the March drop in the Atlanta Fed model.

We know global currencies have been weak; the highlight over the last six months has been the euro. With a lower euro, European exports have actually picked up as of late, and the message is clear: The strong dollar is beginning to hurt U.S. exports. We do not see this changing soon. (As you know, the importance of relative global currency movements has been a highlight of our discussions over the past half year.) Finally, durable goods orders (orders for business equipment) have been soft as of late because of slowing in the domestic energy industry. Again, that is a trend that is not about to change in the quarters ahead given dampened global energy prices.

Like any model, the Atlanta Fed GDPNow model is an estimate. Whether Q1 U.S. real GDP comes in near zero growth remains to be seen, but the message is clear, there is downward pressure on U.S. economic growth. This pressure is set against a backdrop of already documented slowing in the non-U.S. global economy. Perhaps most germane to what lies ahead for investors in 2015 is what the U.S. Fed will do in terms of raising interest rates — or not, if indeed the slowing that the Atlanta Fed model predicts materializes.

We believe this slowing will become a real dilemma for the Fed this year and a potential issue for investors. The Fed has been backed into quite the proverbial corner. Whether the U.S. economy is slowing, the Fed is going to need to start raising interest rates for one very important reason.

It just so happens that the end of the second quarter of 2015 will mark an anniversary of sorts. It will be six years since the current economic expansion in the U.S. began. As of July, ours will be tied for the fourth-longest U.S. economic expansion on record (since the Fed began keeping official track in 1945). There have been 11 economic expansions over this period, so this is no minor feat.

The second quarter of this year will also mark the 6 1/2-year point for the U.S. economy operating under the Federal Reserve’s zero interest rate policy. You’ll remember that, during the darker days of late 2008 and early 2009, the Fed introduced 0% interest rates as an emergency monetary measure. That was deemed acceptable as crisis policy. Given that the FED has maintained that policy, it is essentially saying that the current economic cycle has not only been one of the lengthiest on record, but simultaneously is the longest U.S. economic crisis on record.

As we look ahead, the “crisis” in the eyes of the Fed will come to an end as it contemplates higher short-term interest rates.

Although it still remains to be seen what the Fed will decide and when, there is one very important consideration that must be entering their interest-rate-policy decision making at this point in the economic cycle — a consideration they will never speak of publicly. Let’s start with a look at the history of the federal funds rate (the shortest maturity interest rate the Fed directly controls). Alongside the historical rhythm of the funds rate are official U.S. recession periods in the shaded blue bars.

 

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Chart Source: St. Louis Federal Reserve

There is one striking and completely consistent behavior: The Fed has lowered the federal funds rate in every recession since at least 1954. There are no exceptions. You can see the punchline coming, can’t you? Just how does one lower interest rates from zero to stimulate a potential slowdown in the economy?

Of course, in the European banking system and in the European bond market (government and corporate paper), we are witnessing negative yields. Capital is essentially so concerned over principal safety, it is willing to pay to be invested in a perceived safe balance sheet. Will we witness the same phenomenon in the U.S.? A move to negative interest rates in the U.S. would further punish pension funds, which are not only starved for return but are still underfunded despite fantastic returns for financial assets over the past five years — and Baby Boomers have been rapidly moving into their retirement/pension collection years.

Without venturing into negative-interest-rate territory, the Fed is essentially out of interest rate bullets in its monetary policy arsenal. It’s out of the very ammunition it has employed in each and every recession of the prior six decades. If the U.S. were to enter a recession, the Fed would be unable to act on the interest-rate front, as it has for generations.

Is the U.S. teetering on recession? Not as far as we can see, despite the Atlanta Fed GDPNow model’s reading of very close to 0% growth. We need to remember that U.S. GDP growth has been below average in the current cycle and that the cycle is not young. But the time to contemplate questions such as we are posing is well before a recessionary event. If the Fed is going to raise interest rates, it should be while the economy is still growing. Although the Fed will never speak of this publicly, it cannot be trapped at the zero bound (0% interest rates) when the next U.S. recession ultimately arrives.

The proverbial clock of history is ticking just a bit louder as we enter the second quarter of 2015. Is this, perhaps, the key reason the Fed will need to at least begin raising interest rates this year regardless of the near-term tone to the economy?

Investor Concerns: Greece Is the Word

Unless you have been living on a desert island, you are aware that Greece is in the midst of trying to resolve its financial difficulties with European authorities. This is just the latest round in a financial drama that has been playing out for a number of years now. Up to this point, the solution by both euro authorities and Greek leaders has been to delay any type of financial resolution. And that is the exact prescription handed down just a few weeks ago as Greece approached a February month-end debt payment of a magnitude it could not meet. Greece has been given another four months to come up with some type of restructuring plan. At this point, we’ve simply stopped counting how many times euro authorities have kicked the Greek can down the road.

Why all the drama regarding Greece? Greece represents only about 2% of Eurozone GDP. Who cares whether Greece is part of the euro? The Greek economy simply isn’t a big enough piece of the entire euro economy to really matter, is it?

The fact is that the key problems in the Greek drama have very little to do with the Greek economy specifically. The issues illuminate the specific flaw in the euro as a currency and the fact that the euro authorities are very much hoping to protect the European banking system. The reason we need to pay attention is that the ultimate resolution of these issues will have an impact on our investment decision making.

A key characteristic of the euro, which was formed in 1998, is that there is no one overall guarantor of euro area government debt. Think about the U.S. If the U.S. borrows money to fund building bridges in five states, the U.S. government (via the taxpayer) is the guarantor of the debt; it is not the individual debt of the five states involved. Yes, individual U.S. states can take on state-specific debt, but states cannot print money, as can large governments, so there are limiting factors. In Japan, the Japanese government guarantees yen-based government debt. In the U.S., the federal government guarantees U.S. dollar-based government debt. In Europe, there is no one singular “European government debt” guarantor of essentially euro currency government debt. The individual countries are their own guarantors.

The Eurozone has the only common currency on planet Earth without a singular guarantor of government debt. All the euro area governments essentially guarantee their own debt, yet have a common currency and interest rate structure. No other currency arrangement like this exists in today’s global economy. Many have called this the key flaw in the design of the euro. Many believe the euro as a currency cannot survive this arrangement. For now, the jury is out on the question of euro viability, but that question is playing out in country-specific dramas, such as Greece is now facing.

One last key point in the euro currency evolution. As the euro was formed, the European Central Bank essentially began setting interest rate policy for all European countries. The bank’s decisions, much like those of the Fed in the U.S., affected interest rates across the Eurozone economies. Profligate borrowers such as Greece enjoyed low interest rates right alongside fiscally prudent countries like Germany. There is no interest rate differentiation for profligate or prudent individual government borrowers in Europe. Moreover, the borrowing and spending of profligate countries such as Greece, Italy, Spain, Portugal, Ireland and, yes, even France, for years benefited the export economies of countries such as Germany — the more these countries borrowed, the better the Germany economy performed.

This set of circumstances almost seemed virtuous over the first decade of the euro’s existence. It is now that the chickens have come home to roost, Greece being just the opening act of a balance sheet drama that is far from over. Even if we assume the Greek debt problem can be fixed, without a single guarantor of euro government debt going forward the flaw in the currency remains. Conceptually, there is only one country in Europe strong enough to back euro area debt, and that’s Germany. Germany’s continuing answer to potentially being a guarantor of the debt of Greece and other Euro area Governments? Nein. We do not expect that answer to change any time soon.

You’ll remember that over the last half year, at least, we have been highlighting the importance of relative currency movements in investment outcomes in our commentaries. The problematic dynamics of the euro has not been lost on our thinking or actions, nor will it be looking ahead.

The current debt problems in Greece also reflect another major issue inside the Eurozone financial sector. Major European banks are meaningful holders of country-specific government debt. Euro area banks have been accounting for the investments at cost basis on their books, as opposed to marking these assets to market value. In early February, Lazard suggested that Greece needs a 50% reduction in its debt load to be financially viable. Germany and the European Central Bank (ECB) want 100% repayment. You can clearly see the tension and just who is being protected. If Greece were to negotiate a 50% reduction in debt, any investor (including banks) holding the debt would have to write off 50% of the value of the investment. At the outset of this commentary, we asked, why is Greece so important when it is only 2% of Eurozone GDP? Is it really Greece the European authorities want to protect, or is it the European banking system?

Greece is a Petri dish. If Greece receives debt forgiveness, the risk to the Eurozone is that Italy, Spain, Portugal, etc. could be right behind it in requesting equal treatment. The Eurozone banking system could afford to take the equity hit in a Greek government debt write-down. But it could not collectively handle Greece, Italy, Spain and other debt write-downs without financial ramifications.

The problem is meaningful. There exist nine countries on planet Earth where debt relative to GDP exceeds 300%. Seven of these are European (the other two are Japan and Singapore):

Debt as % of GDP

IRELAND                                           390 %

PORTUGAL                                       358

BELGIUM                                          327

NETHERLANDS                                325

GREECE                                             317

SPAIN                                                 313

DENMARK                                        302

SWEDEN                                           290

FRANCE                                             280

ITALY                                                 267

As we look at the broad macro landscape and the reality of the issues truly facing the Eurozone in its entirety, what does another four months of forestalling Greek debt payments solve? Absolutely nothing.

How is the Greek drama/tragedy important to our investment strategy and implementation? As we have been discussing for some time now, relative global currency movements are key in influencing investment outcomes. Investment assets priced in ascending currencies will be beneficiaries of global capital seeking both return and principal safety. The reverse is also true. While the Greek debt crisis has resurfaced over the last six months, so, too, has the euro lost 15% of its value relative to the dollar. Dollar-denominated assets were strong performers last year as a result.

The second important issue to investment outcomes, as we have also discussed many a time, is the importance of capital flows, whether they be global or domestic. What has happened in Europe since the Greek debt crisis has resurfaced is instructive. The following combo chart shows us the leading 350 European stock index in the top clip of the chart and the German-only stock market in the bottom.

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Broadly, euro area equities have not yet attained the highs seen in 2014. But German stocks are close to 15% ahead of their 2014 highs. Why? Germany is seen as the most fiscally prudent and financially strong of the euro members. What we are seeing is capital gravitating toward the perception of safety that is Germany, relative to the euro area as a whole. This is the type of capital flow analysis that is so important in the current environment.

The headline media portray the Greek problem as just another country living beyond its means and unable to repay the debts it has accumulated. But the real issues involved are so much more meaningful. They cut to the core of euro viability as a currency and stability in the broad euro banking system. The Greek problem’s resurfacing in the last six months has necessarily pressured the euro as a currency and triggered an internal move of equity capital from the broad euro equity markets to individual countries perceived as strong, such as Germany. This is exactly the theme we have been discussing for months. Global capital is seeking refuge from currency debasement and principal safety in the financial markets of countries with strong balance sheets. For now, the weight and movement of global capital remains an important element of our analytical framework.

Watching outcomes ahead for Greece within the context of the greater Eurozone will be important. Greece truly is a Petri dish for what may be to come for greater Europe. Outcomes will affect the euro as a currency, the reality of the Greek economy, the perceived integrity of the European banking system and both domestic and global euro-driven capital flows. For now, Greece is the word.