Third quarter GDP of 5% had increased hopes that the U.S. economy had reached “escape velocity” and that robust growth would lift employment and income, enabling the Federal Reserve to raise interest rates this year. The recent revised estimate for fourth quarter GDP was 2.2%. The previous estimate had been for 2.6%. The Fed has been consistently over optimistic about U.S. growth. Our view is that growth will be modest for several more years. Why is that?
We still have much work to do to reduce the overhang of debt that was accumulated during the 1980s and 1990s and which culminated in the global financial crisis. Falling interest rates have reduced the burden on borrowers, unfortunately offering a disincentive to restructure. Internationally, Greece is still struggling, and now sectors of the Chinese economy are showing the strains of too much debt. Domestically, we see mounting student loans and sub-prime auto financing. Until debt levels are normalized, expect growth to be substandard because excessive debt inhibits the ability to spend. Meanwhile, deleveraging is disinflationary, if not deflationary.
The Eurozone CPI for January was -0.6%, a bigger decline than the -0.2% reported for December. The PCE Deflator, the Fed’s preferred inflation index, showed a -0.2% change from October to November and another -0.2% in December. The recent and sudden collapse in oil prices joins the decline in other industrial commodities, such as copper and iron ore. For some sectors, we are seeing both excess supply and reduced demand. Many of the world’s miners increased capital spending to meet China’s demand for raw materials. Those infrastructure projects took years to complete and are now coming on stream as demand has declined. The Chinese manufacturing PMI, both the official and index and the one compiled by HSBC, are now below 50, indicating a contraction in manufacturing. Given little pricing power and slow economic growth, corporations have managed to improve margins as a way to increase profits. As a result of cost cutting, wages and household incomes have been flat.
In challenging times such as these, there are winners as well as losers. We think holders of equities should favor defensive areas that people need in good times and bad. Dividends also offer some cushion. We are currently overweight utilities, healthcare and consumer staples. Those were good performers last year and may hold up well this year, too. Gold has not done much for portfolios recently, but given uncertainties in Ukraine and the Middle East, the collapse in oil prices and possible defaults in Venezuela and Russia, and the lack of a meaningful resolution in Greece, gold may perform better in the future. Since slow economic growth will be with us for longer than anyone would like, we feel that interest rates will remain low longer than many strategists anticipate. From a tactical perspective, we have opportunistically extended maturities when interest rates have backed up, preferring treasuries and quality corporates over high yield.
Fear of deflation has spurred central banks around the world to use aggressive monetary policy to spur consumption and inflation. While there is little evidence that these policies have helped economies to grow or inflate, they have supported financial markets. At some point, markets will come back into synch with economic fundamentals. Meanwhile, deflationary forces will exert themselves. Security selection and timely asset allocation will become increasingly important.
John Hess 
Falgun Jariwala 
Managing Principal Managing Director
jhess@nsinvestors.com fjariwala@nsinvestors.com
www.nsinvestors.com www.nsinvestors.com
- The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
- All performance referenced is historical and is no guarantee of future results.
- All indices are unmanaged and may not be invested into directly.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Stock investing involves risk including loss of principal.