By Jeff Korzenik, Chief Investment Strategist, Fifth Third Private Bank
At long last, we’re ready to move on. For the past four years, economic policymakers have focused on repairing the damage from the financial upheavals of 2008-09. Central banks initiated extraordinary monetary stimulus, governments employed fiscal stimulus, and financial regulators rewrote their rulebooks.
The U.S. Federal Reserve Bank has, in many ways, been at the forefront of these trends. Recent communication by the Fed, which previewed a coming reduction and withdrawal of their asset purchase program, is but one representation of a global shift in policy. While unemployment levels remain elevated and growth depressed, this phase of our economic cycle is ending. In the context of our economic recovery, the Fed’s actions mark a time best described using Churchill’s description of another period of transition, “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
The road back to normalcy
From a policy and economic standpoint, we begin the long trek back to “normal,” a business environment less dependent on intervention, and one driven by traditional cyclical forces. Fundamentally, we can only interpret this as a long-term positive; self-sustaining economic growth is inherently better than growth dependent on deficit spending or distorted interest rates. Like any period of transition, both risks and opportunities arise. In a world where the news cycle so often focuses on near-term problems, however, investors must be prepared to hear more about the former than the latter.
Through our survey of the world’s leading economic countries, we conclude that these economies are experiencing “growing pains.” In the U.S., our growing pains are a reflection of the Federal Reserve’s stated intention of lessening and ultimately eliminating its asset purchase program, “quantitative easing.” To understand the implications of this policy shift, we must understand that our central bank is acting not because of inflation problems, but rather because they anticipate faster economic growth. We suspect, too, that the Fed is wary of creating the sort of speculative asset bubbles to which financial markets are particularly vulnerable in prolonged periods of low interest rates. Finally, we also recognize that the prospective Fed tapering of asset purchases still leaves the central bank with a distinct accommodation bias, as the short term interest rates under its control remain near zero.
In the developed countries of Europe and in Japan, we are a witness to a different set of “growing pains.” Policy makers overseeing these stagnant economies are being forced to restructure after decades of promoting unsustainable policies. Uncompetitive labor rules and excessive social benefits suppressed employment, and incompatible fiscal policies operating under the umbrella of a single currency led to economic upheaval. Japan added to this toxic mix with the high levels of government debt, protectionist policies, a dramatically aging population, limited immigration and other destructive trends.
Unwinding these anti-growth policies of the developed world is neither quick nor easy, but necessary nonetheless. This is long term good news for Europe, but the sort of government spending constraint and required recapitalization of the financial sector point to a very slow growth recovery. In Japan, we appear to be gaining a little bit more immediate gratification in exchange for changed policies, as that nation, the world’s third largest economy, is poised to contribute to world growth for the first time in nearly a quarter century.
The emerging markets offer a third variation to our diagnosis of “growing pains.” These nations are pushing against the limitations of their export-led growth models. In many cases, they have become victims of their own success as wage gains threaten future competitiveness. In other instances, burdensome bureaucracy, corruption and uninspiring currency policies have resulted in inflation; unlike the universally accommodative central bank policies of the developed world, some emerging market countries are witnessing monetary constraint. In order to continue to prosper, policymakers in many emerging economies have started to reduce their subsidy of state-owned enterprises and lessen the burden of their regulatory structure. The sort of restructuring needed for the long term health of emerging economies may be a short term constraint on the ability of those countries to reaccelerate growth.
What should we make of all these “growing pains”?
Our view is that “growing” is the operative word in the phrase. Not only do we see the American economy continuing to expand, but actually accelerate. A traditional cyclical pickup in consumption and business investment in the U.S. comes against a backdrop of favorable secular trends in housing, energy production, and manufacturing. Abroad, Europe appears poised to exit its recession by year end and, while emerging market growth is constrained, it remains at a level that represents a multiple of developed world growth rates. Japan remains a “wild card,” with the strong potential for an upside surprise contribution to world growth. For investors in the world’s stock markets, this suggests continued earnings growth. To the degree that reform efforts are successful, the duration and ultimate magnitude of our bull market could be extended.
We do extend a note of caution to bond investors. The return to normal and more stable world growth suggests that bond yields will move higher, and prices of bonds lower. In other words, the thirty year bull market in bonds has likely ended. Given our continued outlook for low inflation, the backup in bond yields and damage to fixed income portfolios could well be slow-paced and limited. In this environment, bond investors should not panic, but nor should they be complacent. At a minimum, holders of bonds would be well advised to limit their return expectations.
Investors must recognize that our period of growing pains differs from the environment which has dominated over the past several years. The era of emergency “fixes” and guaranteed government support of markets is fast receding. The times we now face may well hold periods where returns among asset classes differ greatly either in magnitude or degree. Despite these challenges for investors, the return to normalcy represented by these growing pains is beneficial, pointing to a less volatile future and more sustainable growth in the economy.