Major stock indexes gained about 13% since mid-February and are finally in positive territory after a steep drop earlier in the year. US stocks ended slightly ahead for the first three months of 2016, mostly due to a recovery in oil prices and continued easing on the part of central banks. The US dollar declined which benefited companies that export. However, declining corporate earnings and fears that the rest of the world will not fare as well as the United States in terms of economic growth will constrain the upside for the rest of the year. The Dow Jones industrial average gained 13% from its low of February 11, a 1.5% gain so far this year. The total US stock market has been flat, up 0.4% so far in 2016, with technology stocks down around (2.5%). Biotech companies, the darlings of 2015, lost 22.4% during the first quarter.
On the international scene, the European stock index has declined 7.7% so far in 2016. This is partially due to challenges of immigration, the prospect that Britain might leave the European Union, and generally moribund growth prospects. The European Central Bank has cut interest rates so deeply that many Euro government bonds now pay negative interest rates. Australia’s resource based stock market declined 4% while China, finally slowing down in a declining economic environment, lost 15%. Japan, one of the worst looking economies in the world, declined 12% during the first quarter. Germany, the strongest per capita industrial economy in the world outside of the US, lost 7.2%.
US Treasury bonds were the stars of the U.S. domestic markets, gaining almost 2% due to the influx of foreign capital into the United States, as our government represents a safe haven in a tumultuous world. Bond investors do not have much to look forward to, however, unless the Federal Reserve follows the Japanese and European central banks by venturing into negative interest rate territory. Conventional wisdom says that the US Fed is preparing to raise short-term rates, at least in part to have some ammunition to fight the next recession. The Federal Reserve chairman has been very clear that any rise in US rates will be slow, given the uncertain global growth outlook.
Crude oil rose dramatically during the first quarter, its first increase in 18 months, while the price for natural gas continued to decline. Gold notched its largest quarterly gain in 30 years, rising 16% while silver gained 12%. Gold-mining stocks were up even more than the metal itself with the two largest gold miners up around 60%.
Global demand for US bonds has been so strong that the difference between the interest rate paid on a two-year versus a 10 year note is almost nil. Foreigners are concerned about the lack of local political stability and economic growth abroad is way below that of the U.S. and this has sent huge amounts of capital into the U. S. markets. This is one of the reasons why US interest rates have gone down rather than up in anticipation of a rise in the official rate.
One major factor needed now for an increase in U.S. stock market prices is increased corporate earnings. Unfortunately, these are forecasted to slump 8.5% from last year and it is the first time since the financial crisis of 2007 where earnings have declined 4 quarters in a row. Sluggish economic growth and uncertainty, the same factors that made the market go up during the first quarter may also serve to mute market gains for the rest of the year. After a seven year bull market, stocks are more expensive than their historical averages as the S&P’s average price is about 20% higher than its ten-year average. Although crude oil prices have rallied 46 percent from their lows, they are still more than 60% off from their highs reached in the summer of 2014. Many oil producers are standing by, ready to pump more energy out of the ground if prices rise so future gains in the price of energy are likely to be limited. Gross revenues at the Fortune 500 companies are forecast to drop 1.1% this year and their ability to affect price increases remain muted which is good news for consumers.
The best performing stocks during the first quarter were Verizon, Walmart and IBM. The worst were J.P. Morgan Chase, Goldman Sachs, and American Express, notably all financials. The market for initial purchase offerings, IPOs, has been dismal so far in 2016. This is usually a sign that the stock market is going to pull back as the last time there was a similar dearth in new issuance was the slowdown of 2009.
Investors are sitting on large amounts of cash and this could drive the market up, even though the economic fundamentals do not warrant a large upswing. Foreign investors have gone back into mainland China, pouring U.S. $2.4 billion into the country through the Hong Kong exchange. Thailand and Indonesia are also attracting investment with their youthful, highly educated populations and favorable business climates. Mainland China is facing the layoff of millions of people from unprofitable state owned enterprises. The resulting malaise that is spreading through China may well continue to plague the developed world’s stock markets, particularly Europe.
The World’s Economy
Several years back, the Federal Reserve said that the U.S. unemployment rate was their key benchmark for deciding when to raise interest rates. Investors are now wondering why the Fed isn’t getting down to brass tacks as according to official statistics, the economy has been generating over 200,000 jobs per month which is the level at which unemployment holds steady or slightly declines. The participation rate, those who are able to work who actually are working, still stands well below two thirds of the population.
Here is an amazing fact: half of American women over the age of 60 are single, living alone and in need of at least a part-time job. At the same time, many “Millennials”, born between 1980 and 1999, are now out of college are also looking for work. This has created a large pool of job applicants so wage inflation in the service/retail sectors remains muted as the majority of jobs being created are modest paying ones in these areas.
Additionally, many white, middle-aged men are having trouble recouping lost wage earning capacity from the layoffs that occurred during the 2007-2009 recession. 86% of Anglo males between the ages of 25 and 54 are presently employed, which is 2.3% or about 1.1 million less than the 10 year average before the financial recession. This is the largest gap of any group and may be one explanation why this group, numbering around 48 million people, is a factor causing some of the strange shifts being seen in the presidential primaries.
Manufacturing companies continue to be pummeled by China’s overcapacity. The situation has gotten so bad that England is considering nationalizing its biggest steel plant so as to perhaps liquidate it in an orderly fashion. When China joined the World Trade Organization in 2001, it was able to take advantage of its pool of educated low wage workers to ramp up production of steel, concrete and other basic building blocks used in infrastructure construction. China’s own demand for materials used to build new cities, highways and public transportation allowed it to boom from 2001 to 2014 and it brought high growth to economies like Australia’s, who exported natural resources to China.
Hundreds of millions of people from China’s countryside moved into cities and the number of people able to buy consumer goods skyrocketed. Unfortunately, the easy money provided by the Chinese banking system has made returns on investments in this and other emerging market companies drop sharply. China is now faced with having to pull back and approximately 1.3 million coal miners, along with 500,000 steel company employees, may be laid off in 2016. The Chinese government has to deal with thousands of protests a day across the country. People who are out of work and those with poor prospects for the future are, and will continue to be, a daunting challenge to the Chinese leadership.
Economies based on fossil fuels have taken it on the chin lately and likely will remain under pressure, due to several factors: Iran reentering the market, Russia pumping energy for all it’s worth to stave off a depression, U.S. fracking technology and concerns about global warming. Recent scientific assessments say much of the world’s known fossil fuel reserves need to stay underground if the world wants to limit global warming to 2° Celsius above preindustrial levels. The international climate deal, sealed in Paris this past December, would create broad economic problems and energy shortages if the countries that signed it try to implement its provisions. Around $1.2 trillion is held in stocks and bonds of fossil fuel companies and if their traditional activities exploration and production activities were to be curtailed, it is estimated that the world’s stock market indexes would fall around 20%.
Europe’s economic issues are best illustrated by what is going on in Italy. While many countries in Europe grapple with the political and economic cost of dealing with the influx of refugees from turmoil in the Middle East, Italy’s main headache is its banking system, which is deteriorating rapidly. Almost 20% of loans in Italy are bad compared with approximately 1% in the US. During the worst part of the financial crisis of the last decade, US nonperforming loans never rose above 3.5 %. Italy is the eighth largest economy in the world and its government debt is already 132% of gross domestic product and rising. Economists postulate that anything over 100% is considered to be a harbinger of bankruptcy. Italy’s current level of 132% would go to 152% if they wrote off their bad loans and acknowledging the poor condition of other Italian securities related to these bad loans would increase that number another 10% so the true current level of debt to GDP is really 162%.
One proposed solution for Italy’s predicament is to create a “bad” bank and move all the non-performing loans to this new bank with some form of government guarantee. Government guarantees from Italy are fairly meaningless without the backing of the German government, which is very wary of committing to make good on the poor results of another country’s financial sector. Over the next several years, the banking crisis in Greece and Cyprus may end up looking fairly benign compared with the challenges that Italy represents to the European Union.
The migrant crisis in Europe has paralyzed the European Union and ties between its members are fraying over disagreements about border controls, the cost of integrating immigrants into local economies, and potential solutions to stemming the future flow of refugees. The increased frequency of terror attacks in Europe is starting to turn public opinion against the refugees and it may be the German Prime Minister’s undoing. It is unlikely that England will vote to exit the European Union because it is already somewhat insulated from the economic excesses of the EU. The political isolation that would follow a British vote to withdraw is not something any entrenched politicians there want to face.
The Big Fix (as opposed to the Big Short or the Big Chill)
One thing that seems clear is that a multitude of past efforts on the part of central banks in the developed world’s economies to ignite growth has, by and large, failed. Deflation, a condition many of us thought would never be seen in our lifetimes, does exist and in fact is just another word for lack of growth. The political risks in China, the United States and Europe, of failing to provide enough decent jobs to growing numbers of educated people threatens to undo many of the political alliances that brought relative stability to the world since World War II.
To deal with the lack of growth, central banks are now promoting negative interest rates and there is talk about banning the use of cash, which is an interesting but impractical concept. While the world’s banking system has been shored up by allowing banks to expand the definition of suitable collateral, the actual growth in real lending activity has been dismal. Monetary policy has failed to pull the world economy out of the great recession so what are the alternatives?
Traditionally, governments have joined the economic fight alongside central bankers but this has not been the case due to political disarray in the United States, bureaucratic stalemates in Europe, timidity in Japan, all of which has precluded governments from creating large spending projects on public works and infrastructure which would, in fact, put people to work. With an inordinate fear of deficit spending evident in the rise of the Tea Party in the United States, few politicians are willing to promote these kinds of ideas. The fact that deteriorating roads, bridges and other public facilities are crying out for such attention, along with our need to initiate technology infrastructure that other countries have already put into place, highlights the political barriers we face to remain competitive for the rest of this century.
The German government is also set in its ways against government spending, even though borrowing costs have never been cheaper. One option currently being debated by the E.U., Japanese and U.S. central banks is something called “helicopter money”. This means that the government creates money by printing it and, bypassing banks and financial markets, puts it directly into consumer’s hands. What a firestorm that would set off! Japanese leaders are considering this measure because after 20 years of failure, evidenced by persistent deflation (lack of growth), what else can they do?
Another idea is to mandate an increase in minimum wages such as being considered by state legislatures in New York and California. If companies pass along these costs to consumers, it would create price inflation which in some economist circles is a good thing. The theory is that inflation will encourage people to invest their capital now instead of holding back for future deployment, thereby igniting growth in the real economy.
Cutting taxes has been shown to ignite economic activity but again, with deficit spending unpopular in the extreme, it is unlikely that any politician will take action, especially when it appears to further widen the gap between the 1% and the 99%. Writing off government debt is probably inevitable in many countries, but doing it sooner rather than later, while politically unpalatable, would help banks meet new capital rules. Once the shock of the default wears off, government write downs might promote businesses to borrow once again in order to expand capacity. In the same light, reducing regulation has the same effect as cutting taxes, in that it makes the cost of conducting business go down, and this theoretically promotes growth in the form of new business creation and expansion of existing businesses.
The common theme of all of these steps to promote growth is that if you are trying to get (re)elected, you would have to be crazy to try and do any of them. The underlying contract between democratic governments and their citizen base is based on three premises:
- Rich people should pay more in taxes than poor because they can afford to and they benefit to a greater degree from a stable environment;
- Systems in place for taxation and the spending of public funds should be able to be understood by the common person and therefore people will voluntarily comply with the rule of law and:
- Individuals can make choices about how to deploy their time, energy and money and their options are not unduly affected by government interference.
All three of these assumptions are under attack. The demographics of an aging world with fewer decent employment opportunities being created requires creative thinking but politicians are less and less able to exercise their imaginations. There is an unwillingness to take chances and implement bold long-term plans because of day-to-day budgetary pressures and this constrains good people of all persuasions from taking action on matters of public interest.
Now that central banks have tried and failed with traditional monetary tools, the logical thing would be for governments to step up and implement structural reforms. The failure of governments to do their part helps explain why nontraditional candidates in the United States like Trump, Cruz and Sanders are playing an important role in the debates. Will the next president have the guts to take on these challenges? We are not counting on it.
Rob: New Mexico entered the winter with a great deal of moisture but it now looks like El Niño has dissipated as conditions are dry as a bone in the garden. To make up for the lack of precipitation, I’ve embarked on a program of brewing kombucha, a non-alcoholic, probiotic fermented drink championed for centuries in parts of Asia. Given New Mexicans’ propensity for red or green chile, my recipes are moving towards a tangy ginger green versus a more therapeutic but spicy red. For those clients brave enough, samples are available at the office. Later this spring, the large-scale egg tempera installation on view in Santa Fe over this past winter will be moving to North Carolina.
Kyle: In December, my family and I adopted a dog from the Espanola Valley Humane Society. Nick is a shepherd mix and has more energy than I ever would have imagined and requires a good amount of attention. With summer coming, I think Nick will enjoy getting more time outside hiking and playing to use up some of his energy. After a few years off, I recently started mountain biking again and am really looking forward to getting out as much as possible while the weather is nice.
Lauren: Despite our occasional late-season snow, the weather is certainly warming up and I have loved spending more time outdoors. The start of the year has been busy with travel and planning for the year to come. I was able to visit Death Valley during the “super bloom” of wild flowers and spent some time in Rhode Island with my brother and his wife. My biggest piece of news is my recent engagement and I have been swept up in a flurry of planning for our September wedding here in Santa Fe. It has all been very exciting, albeit a bit stressful, and I am looking forward to celebrating with our two families in one place for the first time.
Jeff: My wife and I are scheduled to see some friends in Boone, NC at the end of April. We planned the timing of the trip so that we can also attend the “MerleFest” which is a music festival that is named in the memory of Doc Watson’s son, Merle. The festival has grown to where now it is 4 days of continuous music with about 10 different stages going at all times. I continue to play music at various retirement homes throughout Santa Fe area which is great fun.
Robyn: I am settling in nicely at The Rikoon Group and learning so much. The performance of Alfred Hitchcock’s play “The 39 Steps” at the Santa Fe Playhouse went very well, as out of a three week run of 12 performances, 9 sold out! Santa Fe is home to The International Shakespeare Society and they are preparing a new YouTube channel for Shakespeare on Camera for which I will be contributing a monologue from Romeo and Juliet. At the same time, I am participating in a scene study class being offered locally with Wendy Chapin, a well-known director. For my 30th birthday I will be headed to Ithaca New York to do a seven day silent meditation retreat at the Ithaca Zen center in New York. Last month, I visited Asheville to check up on our various private real estate and private lending projects and as always had a wonderful time. Patricia and I are looking forward to planning the office spring garden and getting the baby plants started in the grow dome soon.
Dana: This is my 10th year of beekeeping and sadly, I sustained the greatest ever winter losses. I’m hopeful that my one remaining hive will rebound enough to make a late Spring divide. On the bright side, the flowering almond trees up on Museum Hill are covered with bees.
Our regularly scheduled discussion group that takes place at our office and over the phone will happen the first week of May so please check your calendars upon receipt of this commentary. On Tuesday, May 3, we will host our” tea” at the office located at 2218 old Arroyo Chamiso in Santa Fe. It goes from 3:30 to 5:00 PM and then on May 5, we will have our phone call-in discussion, again from 3:30 to 5:00 PM. Please let us know if there are any topics you would like to see discussed at either event. To call-in, please dial 1-866-546-3377 and enter code 470070 when prompted.