America's remarkable teflon economy
The U.S. economy continues to firm and appears more robust than other countries. The U.S. dollar has strengthened and Federal Reserve policy remains easy.
In its final estimate of U.S. Gross Domestic Product (GDP), the Bureau of Economic Analysis reported that the economy expanded to a 4.6% annual rate in the April to June quarter, up from a 4.2% annual rate estimated late last month.
The increase in real GDP in the second quarter primarily reflected positive contributions from personal consumption expenditures, exports, private inventory investment, nonresidential fixed investment, state and local government spending, and residential fixed investment.
With inflation subdued, and deflation risk threatening Europe and Japan, the Federal Reserve is moving cautiously. Because the central bank's balance sheets are inflated, a net long-term view is important.
The Federal Reserve is set to finish additions to its balance sheet this October and exit from its emergency policy (QE), and move to a tightening cycle in 2015 away from the emergency interest rates (ZIRP).
Liquidity remains ample, and broader sentiment continues to be cautious. Presently, real rates have been dropping, particularly on the long end of the curve, which comprises most of the decline in U.S. rates. The 10-year Treasury is below the 3% level at which it began in 2014.
Treasuries have been driven by a steady uptick in demand of bonds placed against a slowdown in real supply. Because of the improving U.S. trade deficit, primarily due to energy independence, the Treasury Department is issuing fewer bonds and is now less dependent upon foreign buyers to purchase them.
During this past quarter, geopolitical tensions have increased: the Russia-Ukraine conflict, the rise of the Islamic State, growing turmoil across the Middle East, China's territorial disputes with its neighbors, and mass protests in Hong Kong.
The equity markets appear to be resilient to the new and continuing macro risks. The turmoil in the Middle East or Ukraine has not triggered a massive shock to oil supplies and prices like those that occurred in 1973, 1979, or 1990.
There is excess capacity in global oil markets. Oil prices are stabilizing in the $90 to $95 range recently. U.S. crude oil exports are at their highest level since March 1957.
Nominal stock prices are at an all time high, and there is a lack of retail inflows into stocks. Inflows into equity funds compared to bond funds still remain below levels seen at prior peaks.
Although challenged, we are very positive on the equity markets for several reasons. Corporate balance sheets are in good shape, while the ratio of bank capital-to-assets is at the highest level in the post-war era. Stock market correlations continue to fall.
This is a welcome development for active managers. Because inflation and long-term interest rates are historically low, it is difficult to argue that equity valuations are excessive.
Historically, interest rates between zero to 4% and low inflation are the sweet spot for equity valuations.
Capital equipment spending appears to have more upside as corporations begin to deploy their excess cash on finished goods rather than share buybacks.
Based on gasoline prices, mortgage rates, rising household net worth, repaired balance sheets and improving confidence, we also believe U.S. consumer spending will continue to grow and contribute about two percentage points in GDP.
Corporate profits should eventually provide the basis for job growth. The U.S. and the developed world are reliant upon services, consumption, and a highly skilled labor force for their economies to prosper.
Because the cost of capital has been so low and the labor force so plentiful, investors have been rewarding public companies for short-term gains rather than for long-term investments.
We believe that this will change as labor's share of GDP turns around. The second half of a business cycle is about paying both labor and capital together as wage growth trends to accelerate.
Over the next decade, labor force participation in the developed world is likely to continue to decline due to demographics, which will affect the supply of labor.
Technological trends are favorable for the economy. Energy independence, especially from fracking, is one of the largest reasons the U.S. trade gap has improved. Robotics are being used to aid in tasks for the elderly, surgeries, and dangerous situations.
The move of data to the cloud is organizing the massive data overload in the 21st century. Applying automation to the manufacturing process is huge. Affordable 3-D printers can physically print real prototypes at home.
Smaller and more durable items are made available by advances in material science. Quantum computing is able to perform complex calculations, especially helpful in defense communications. The U.S. remains a great center for the next candidates of innovation, and we are optimistic that these advances will make a difference.
In 2014, we had believed that the economy would strengthen and interest rates would begin to increase.
With severe incremental weather in the first quarter, increased geopolitical instability, and continued economic weakness abroad, Martin Investment Management, LLC now believes that we are still in an economy of two steps forward and one step backward.
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