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World Economic Outlook:
The predominant sentiment in current financial markets is defined by uncertainty and a risk of global deflation. A stream of disappointing economic data and the Chinese economic slowdown has again postponed the Federal Reserve’s stated intention of raising interest rates, this time until December. We now face the question of whether this will be the first economic cycle in the last century where the US has not raised interest rates after an economic recovery. This would be similar to Japan, where deflation and stagnation have prevented any interest rate increases for the past 20 years.

A host of recent economic data suggests that growth is now slowing in the US. The gauge of US business investment plans fell for a second straight month in September, as did consumer confidence, perhaps a result of recent worries over moderating job growth. Other data, ranging from trade to retail sales, and industrial production, suggest that the US economy has lost momentum in the third quarter, when US GDP only expanded at a 1.5% annual rate, slowing from a much more dynamic 3.9% rate in the second quarter. This was reflected in the fact that job growth decreased in August and September.

During the past five years, earnings within the S&P 500 index have grown at 6.9% annually on average, which is low compared with past economic expansion. Furthermore, only half of this has come from improving profits; the other half comes from earnings-per-share improvements which arise from record levels of share buybacks. This implies that both the quality and quantity of earnings growth over the past five years has been deficient, and that the bull market has taken place despite mediocre earnings growth at American companies. At the same time, business investment in capital expenditure is weak, and in fact is weaker than during any of the last six post-recession recoveries. This is due to the exaggerated "easy money" policies of the Federal Reserve which have only served to shift investment away from the real economy and into financial assets.

An unwillingness to invest in real assets is due to uncertainty by business owners about how central banks will unwind "Quantitative Easing", the policy of printing money in order to stimulate the economy. They prefer to invest in financial assets (such as their own shares), because shares are more liquid than factories if they need to be sold. Financial assets have benefited from the Federal Reserve's quantitative easing, but the real economy has benefited less so, which calls into question the durability of the bull market in those financial assets.
As recently as September 24, Janet Yellen at the Federal Reserve indicated that a vast majority of her colleagues supported an interest rate hike this year, and that she personally shared this view. While a majority of economists believe this will be the case, there remains tremendous unease and uncertainty on the subject. If a global recession is underway, our US rate hike would be negative for stocks, because it would drive the US dollar even higher which will impact earnings for US exporters negatively. 45% of the revenues of S&P 500 companies are exports, which are impacted negatively by a strong dollar reducing their profitability. We have now seen two consecutive quarters of falling sales growth in the S&P 500.

China has been the key factor in global risk aversion this year. The five-year plan, approved last week but not revealed until next March, is likely to include many fiscal policy measures aimed at stimulating the economy. "Official" growth in China has fallen below 7% for the first time since 2009, to 6.9% in the 3rd quarter. China cut interest rates for the sixth time this year a few weeks back to stimulate slowing growth. Short-term rates now stand at 1.5%. China's Communist Party is attempting to adjust the economy to one which relies upon a more sustainable model based on domestic consumption rather than exports and state investment. It is known that this adjustment process will negatively impact growth in the short and medium term; what is less well known is for how long this will drag on the world economy. Chinese factory output is at its lowest level in 6.5 years and the Chinese purchasing manager’s index indicates that the economy is in contraction.

Chinese electricity consumption, which has been on a downward trajectory since 2009, suggests that Chinese GDP is far below what the government says it is. For the first half of 2015, electricity grew at only 1.3%, which is the lowest figure in 30 years. The overall slowdown has impacted commodity and oil prices dramatically. Chinese cold rolled steel prices are down 40% this year, copper is down 24%, (79% from its 2011 highs), iron ore is down 38%.. Crude oil is down 23% this year, (60% from the high in 2011), and lumber is down 34% year to date.
Commodities are priced in dollars worldwide, so weak commodity prices strengthen the dollar against other world currencies. Thus, the US dollar index has appreciated by 8% in 2015. A raising of US interest rates would further strengthen the dollar, as would further European Central Bank economic stimulus. In August the Chinese Central Bank devalued its currency by the largest amount (3%) in twenty years, in order to boost their export driven economy. This move roiled global stock markets, and led to capital flight out of China. Many investors believe that there will be more Chinese devaluations ahead.

Saudi Arabia needs oil at $106 to balance its budget. The current price is $45. The IMF estimates that within five years, Saudi Arabia will be out of cash. They have raised $4 billion by selling a bond issue to local banks earlier this year. More importantly, they have pulled out over $70 billion over the last six months from investments in the US stock and bond markets. The credit rating of the country has just been cut on October 30 to A+ from AA- by Standard and Poor’s, which said the biggest OPEC producer’s fiscal deficit will increase to 16 percent of gross domestic product this year as crude prices slump. Their outlook is negative. All of this raises an important question; as emerging market and oil based economies see decreasing revenues, will they continue to sell assets currently invested in the West?

China, for example, owned $1.3 trillion of US debt at the end of June. The capital outflows from China this year have increased alarmingly, mostly due to the domestic stock market selloff, and fears of further devaluations of the Yuan. Beijing has been selling US treasuries in order to buy their own currency back, to prop up a Yuan which has been under intense selling pressure. At the same time they have spent $236 billion supporting their own stock market. As a result, they have been selling US treasury holdings in order to raise cash, in an amount estimated to be as high as $100 billion in August. While this has not yet impacted the US bond market, there are reasons to believe that bonds have now reached peak values and will begin to lose value as we enter a tightening cycle by the Fed. For the moment, slowing global growth has clouded the world economic outlook, driving investors into what they perceive as safe US government debt. So far, buyers have compensated for Chinese selling. Will this continue with bond yields near 30 year lows? China's foreign exchange reserves peaked at $4 trillion in 2014. They are now down to $3.5 trillion, and capital flows out of China are at record levels because of slowing growth, rising levels of bad debt, and fears about further devaluations by the PBoC.
Japan began its own massive stimulus programs in April 2013 and stunned the world market one year ago when it increased that program. Yet Japanese growth remains negative, and inflation is still at zero, far below the Bank of Japan target of 2% indicative of a healthier economy. Real wages in Japan are at their lowest level since 1990. The number of households living on welfare, which has been rising for 20 years, has just hit a new record. The entire Japanese middle class is threatened. It is looking increasingly as if output will fall further in the third quarter of 2015.

Emerging market economies are also struggling. Brazil’s economy will contract this year by 2.5%. The country was downgraded to ‘junk’ status recently by Standard and Poor’s. The Prime Minister could face impeachment on corruption and bribery charges between herself and members of her party and Petrobras executives. The head of the Brazilian Congress has indicated that it is already too late for Brazil to avoid further downgrades of their credit rating in the near future, as the Brazilian currency hits new lows after having lost 38% against the USD this year. The lower oil goes, the worse shape Brazil is in. Lower oil prices are likely to negatively impact any country too economically dependent upon oil, including Russia, Venezuela, Kazakhstan, Saudi Arabia, Iran, Nigeria, Norway, Ecuador, and Mexico. Countries highly dependent upon commodity exports, such as Australia and Canada, are also suffering, and their currencies continue to weaken as a result. In the case of Australia, there is a rising risk of a domestic recession next year due to falling basic material export prices, collapsing capital expenditures as miners wait out the storm, and consequences to the Australian consumer.

One potential crisis is the amount of US dollar debt accumulated by local companies in emerging markets, which has doubled in the last seven years to $6.8 trillion. These debts become harder to pay as the US dollar rises, which it has by 8% so far this year. This was a much discussed topic among the world’s central bankers when they met in Jackson Hole, Wyoming in September.

Another disturbing trend is the decline in world trade growth. The Economic Cycle Research Institute (ECRI) just published an article discussing the large decline in global trade growth, specifically mentioning that year-on-year world trade growth is nearing zero. After almost four years of falling export prices and major policy stimulus, export price deflation is almost at a point that compares to the financial crisis of 2008.

The International Monetary Fund cut its forecast for global growth earlier this month down to 3.1% from 3.3% for 2015, and cut its growth estimates by a similar amount for 2016 as well.

In Europe, there is continued deflation, slow growth, and much excess capacity. The output gap, or the difference between the actual output of Europe and its potential output is still enormous, especially when seen through the lens of Euro-area unemployment, which currently stands at 11%. With unemployment that high, there is no chance of inflation anytime soon. What is even more unsettling and destabilizing is the largely male and Muslim migrant flows which are spiraling out of control. The refugee and migrant flows are causing unpredictable and unforeseen political tensions with the EU and within countries like Germany, who are realizing how unprepared they are for this humanitarian catastrophe. Europe expects to receive over 800,000 refugees this year, with Germany taking 450,000 and Sweden expecting 190,000. However German authorities now state that they are at their “limit”, while anti-migrant protests flare in Eastern European capitals. Hungary has built a fence along its 415 mile border; Slovenia is threatening to do the same. The Hungarian Prime Minister has accused Angela Merkel of living in a “dream world” and causing “chaos”. As commendable as Merkel’s efforts have been, she is now facing stiff resistance from within her own political party.

Europeans do not have the best track record when it comes to accepting cultural and religious diversity. It is difficult to interpret the refugee crises in Europe as a positive for the European economy, which at best will be socially destabilizing in very unpredictable ways, not least of which could be a rise of far-right wing political ideology.

Stock Market Perspectives:
Financial markets have been booming for the past six years while the US economic recovery has been mediocre at best. Stock valuations rose to unsustainable levels based upon the narcotic of easy money. Now that this era is coming to an end, there may be an uncomfortable period of “withdrawal symptoms” ahead.
It should be noted that the S&P 500 Buyback Index, which tracks the 100 stocks with the highest buyback ratios, is lagging the S&P 500 Index by 3%, which is a sign that the key driver of the US stock market is losing energy, because the reverse should be true. The largest buyer of American stocks this year has been corporate buybacks, or the listed companies themselves who have been repurchasing their own shares. This is not a wise use of capital, as it is not being invested for future growth. Stock buybacks benefit stock prices, which, in turn, tend to benefit executives and board members most. It’s no wonder that in the month of October, officers and directors at S&P 500 companies are personally selling 11.6 times more shares for themselves than they are buying, even while their companies buy back shares!
S&P 500 corporate buyback announcements have jumped by 50% since last year to $521 billion. And yet, these companies are underperforming the broader market. What can we conclude about this? That pension funds, households, mutual funds, international investors are selling these shares faster than corporations can buy back their own shares. This is not sustainable.
Buyback mania ends badly. The last time corporate buybacks peaked was in the third quarter of 2007, another year when, interestingly, the buyback index lagged the general market. Stocks proceeded to selloff for the next eighteen months afterward.

The Shiller Cyclically Adjusted P/E ratio of the S&P 500 index, created by economics Nobel Laureate Robert Shiller at Yale University is currently at 26.4 earnings, 59% higher than its historical mean of 16.6.
Using Dr. Shiller’s methodology, the stock market is at its most expensive in 135 years, except for 1929 and 2000.

To summarize, high US stock valuations are being challenged by tighter financial conditions, led by a higher dollar and a sense that years of easy money has borrowed from future stock performance. This comes at a time when continued stimulus in the rest of the world may drive the value of the US dollar much higher. Stock market valuations are expensive, and may revert back to levels closer to their average.

Bond Market Perspectives:
Unprecedented stimulus by the Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan have involved central bank purchasing of government bonds with printed money. To date, the Federal Reserve has purchased over $3 trillion of US bonds since 2008. The ECB began its bond buying program earlier this year, and has so far purchased €341billion of an intended €1.2 trillion of European bonds. Last June, The Bank of Japan became the biggest holder of Japan’s sovereign debt for the first time, with ¥201 trillion of holdings ($2 trillion), bypassing the amount held by domestic insurance companies. While this policy of “QE” has now ended in the US, it continues in Europe and Japan.
Individuals have a difficult time understanding what this means, so to put it in easy terms it is like paying off a credit card with another credit card whose spending limit is 100 times higher, and then going on a shopping binge.

Current bond yields are the best predictor of bond returns, and bond yields are historically low. Interestingly, the Dutch government bond yield is at a 500 year low (Holland is the only country with data going back that far). Over the past thirty years global stocks have returned 7.5% above inflation. Over the same period, the US aggregate bond index delivered 6.6% above inflation. A buyer of a 30 year US Treasury bond in the spring of 1985 would have received nearly a 9% yield after inflation, with a yield of 11.5%. A buyer of a 30 year US Treasury bond now should expect a yield of only 2.77%. Elsewhere, it’s worse: A 30 year UK Gilt yields 2.62%, a German 30 year Bund yields 1.26%, a Japanese 30 year Government Bond yields 1.34%, and a Swiss 30 year Government Bond yields 0.46%! Given that long term inflation in the US is expected to be 2.1%, the “real” yield, after inflation, will barely be positive FOR THE NEXT THIRTY YEARS.

Are bonds a good investment? No. Firstly, they offer a miserable “real” yield after inflation. Secondly, there is too much supply as governments, states, municipalities, and corporations stuff themselves with ever more debt. Third, and perhaps more importantly, there will be a time in the not too distant future when worries about repayment overwhelm the world economy. Investors are overlooking the fact that credit downgrades are happening everywhere at a sovereign level, including the United States, which was downgraded by S&P from AAA to AA+ in 2011. Since December 2008, the number of triple-A sovereign countries has fallen to 12 from 18 due to the Eurozone crisis of 2011 and the downgrade of the US to double-A-plus in 2011. Most recently, Finland lost its triple-A rating last October.

Governments cannot stop increasing their spending and borrowing. In the US, outlays as a share of GDP are projected to rise significantly more than revenues over the coming decade—by two percentage points, from 20.3 percent in 2015 to 22.3 percent in 2025. The increase in spending reflects substantial growth in the cost of benefit programs that are targeted toward the elderly, related to health care, or both, as well as a sharp rise in payments of interest on the government’s debt; those increases would more than offset a significant projected decline in discretionary spending relative to the size of the economy. The projected deficit remains roughly stable as a percentage of GDP at about 2.5 percent through 2018 and then starts on an upward trajectory, growing from 3.0 percent of GDP in 2019 to 4.0 percent in 2025. By the end of that period, the Congressional Budget Office projects that annual deficits will be well above the average of 2.7 percent of GDP over the past 50 years.
The US Treasury predicts that an increasingly large share of the government’s gross borrowing, excluding T-Bills, will be used to roll over maturing debts rather than expand the total stock of debt.
None of the above can be considered good for the bond market, and would point to higher yields and lower bond prices ahead. But what would the impact of higher bond yields on the stock market be?

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  Consumers and businesses would be faced with higher interest rates, meaning that they will borrow less and will pay higher rates of interest on their loans. This reduces consumption. Less business spending can slow down the growth of a company, resulting in decreased profit.

  
  


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  One popular stock valuation method, the dividend discount model, takes future cash flows of a company and discounts those future flows back to today. If a company is seen as cutting back on its growth spending or is making less profit - either through higher debt expenses or less revenue from consumers - then the estimated amount of future cash flows will drop. Furthermore, if the interest rate used to discount those future cash flows rises, then the present value of those flows falls, even if everything else remains equal.

  
  


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  When interest rates go up, the “risk-free” rate of return goes up, meaning that the total required return for investing in stocks, which is a risky asset, goes up. If perceived risk goes up, but returns stay the same or go down, some investors will shift out of stocks. So higher interest rates also change perceptions in the market about the riskiness of stocks.

  
  


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  In view of the elements outlined above, it seems prudent to wait for lower levels before becoming reinvested. The marginal reward of a slightly higher new high in the stock market does not seem to be worth the risk of a major selloff as the world heads into a deflationary slump.

  
  

If the market does experience a pullback, there will be strategic opportunities ahead, particularly in financial stocks, some of which greatly benefit from higher rates. Domestic companies with little international exposure, as well as companies whose inputs come from abroad, may also outperform.

Grant Rogers

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