America Has Its Swagger Back. But For How Long?
- by Ryan A. Hughes, Bull Oak Capital
America has its economic swagger back. And it’s about time. Cue the theme song from Rocky and break out your American flag t-shirt. That’s right, the greatest nation on Earth has returned to the economic forefront. But, as always, there are threats to the U.S. recovery: the likely eurozone recession, the Chinese slowdown, and the fallout from the oil price drop. While the U.S. never stepped aside from the center of the economic stage, for a while we certainly lost our edge.
Things got a bit crazy during the Great Recession. Think back 6 years ago during the height of the economic panic. The unemployment rate was at 9% and rising. The fallout from the U.S. housing crisis led to the U.S. financial system nearly collapsing. Keep in mind that if the U.S. financial system failed, the global economy would have fallen apart. We are talking about the Great Depression Part II. Believe it or not, while all of this was happening, most “financial professionals” had no idea what was going on. Even worse, those that did had no idea how to fix this mess. Hats off to Ben Bernanke. In my humble opinion, he and his team truly orchestrated the U.S. recovery. While some of the plans he implemented could have been better handled, he was given a very large task and very little time to accomplish it. This economic disaster seemed to come out of nowhere (at the time) and it truly threatened our entire way of life.
I didn’t write this piece to remind everybody of how awful 2008-09 was. Rather, I hoped to put things into perspective. While the recovery has taken longer that most predicted it would, we have finally arrived. U.S. GDP growth is at the highest level in 11 years. The latest U.S. GDP growth was at 4.05% (Sept 2014) and it is forecasted to grow at 3.2% this year. The average historic GDP growth has been at 3.00%. A true economic recovery requires 3+% growth to make up for lost time. However, this recession is unique in that it has taken the longest to recover from. See below:
-The Recession Convergence Curve
Source: Dr. Edward Leamer - July 2012
Nonetheless, robust economic expansion is finally here as consumers are consuming more and U.S. employment numbers continue to improve. Ben Bernanke’s grand QE experiment that lead to higher asset values and lower interest rates has worked. U.S. GDP growth is finally growing 3+% and the unemployment rate, at 5.6%, is continuing to fall. Of course, nothing is ever ideal and our nation still has plenty to contend with. For argument's sake, here is a short list of my domestic concerns:
1. While the unemployment rate is at 5.6%, the number of individuals actually participating in the labor force has continued to decline. The U.S. civilian labor force participation rate is at 62.7%, the lowest level since 1978.
2. The average debt outstanding per household is at $90k! This includes credit card debt, home mortgage, and student loans. With the median household income at $52k, this hardly makes me optimistic. While debt makes the world go around, $90k per household makes me uneasy.
3. With the U.S. dollar strengthening, U.S. companies will likely export less and consumers will import more. While this is good for U.S. consumers, this is unfavorable for those companies hoping to export goods at a competitive price. This can certainly impact corporate earnings.
4. The U.S. stock market is at the upper-end of being fairly priced. The S&P 500 P/E ratio is 19.09. The CAPE Ratio is 26.56. The P/B ratio is 2.75. All of these figures are a bit pricey. These ratios are reasonable as long as corporate earnings growth continues to justify those multiples. If corporate earnings fall by the wayside, then these multiples suggest that the market is too expensive.
So far, I have only focused on domestic issues. If America hopes to continue its economic recovery, the most important and critical factors rely on the outcome of these external forces: the severity of the European recession, Chinese growth rates, and the true impact of the oil price crash. The global economy is, of course, global. The many and different world economies are intertwined and we all rely upon on each other. What happens on the other side of the globe really does impact us here in the U.S.. Sir Isaac Newton wrote his Third Law with physics in mind. However, I find it very appropriate here, “For every action, there is an equal and opposite reaction.”
The European Recovery That Won’t Occur Anytime Soon
We have been hearing the same economic story from Europe for the past 5 years now: “Slow growth, high unemployment, persistent deficits, and low inflation” and it’s not likely to change anytime soon. For those reasons, I’m a bit skeptical about any European recovery. Not that I have anything against our friends across the pond, I just think that the Europeans are faced with extremely daunting issues. With an aging population and massive amount of debt, few believe that anything but sluggish growth will continue.
Not all is lost, though. Mario Draghi, the European Central Bank’s head, has just announced a European version of quantitative easing this week. The ECB is planning to purchase as much as €1.1 Trillion in government bonds in an attempt to mimic the success of the American QE program. With an unemployment rate at 11.5% and many participating countries facing deflation, this is a long awaited step. However, conditions could worsen before they get better.
While I applaud the EU for finally implementing an asset purchase program like this, more needs to be done. This is only a temporary fix to a larger problem. Nothing can replace fiscal reform. Print all the money you want, but budget cuts and debt reductions are the only way to get out of this burgeoning debt problem. The EU is comprised of many different countries with many differing opinions. I personally believe that a concerted effort bring a coordinated fiscal plan is nearly impossible. If I am correct, then I suspect that the EU will continue to grow at a disappointing pace.
Chinese Growth Rates: Can China Continue To Perform The Improbable?
Earilier this week, Beijing reported that China’s 2014 expansion of 7.4% was the slowest pace in nearly 24 years. As the second largest economy in the world influencing about 11% of the global growth, China has a vast effect on the world. 2014 is also the first time that the country missed its annual target in 16 years. So, what gives? China's economy has been rumored to crash land for a few years, correct? This slowdown can be attributed slowing consumer demand, rising debt levels, and a volatile real estate market.
The International Monetary Fund has predicted slower growth for the country at 6.8%. Additionally, most economists expect China to continue to slowdown as China attempt to transition from a production-driven economy to a consumer-driven economy. This slowdown is concerning as China has been a major part of the global growth for the past few decades and a major driver of the commodity cycle. Their past-paced growth has benefited many countries that have exported goods to the country. Most expect the slowdown to impact commodity-exporting regions the most, such as Australia, Malaysia, and Africa.
The slowdown in China will not, however, impact the U.S nearly as much. China represents 7.5% of U.S. exported goods. This includes agriculture, energy, manufactured goods, and non-agricultural commodities. According to a recent study by IHS, if China were to experience a hard landing, the U.S. is expected to diverge from the baseline GDP projection by only 0.5%.
But what about those countries that we do export a lot to? I was curious to see if a China slowdown would significantly impact their economy to the same degree. The U.S. exports a significant amount of goods to Canada (19.3%) and Mexico (14.8%). As it turns out, both countries export ~2% of their goods to China, leaving them well insulated if China were to experience a hard landing.
The Decline in Oil and its Global Effects
The recent crash in oil prices has sent shock waves throughout the world. In 6 short months, crude oil prices have declined by more than 50%.
A lot has been written about the cause of this crash. Most believe it is due to the oversupply of oil and the waning demand for it. The U.S. shale oil boom has increased oil inventory, while the European/China/Japan slowdown has decreased demand. Since the U.S. shale oil boom began in 2009, U.S. market share increased from 7% to 12%, while OPEC’s (plus Saudi Arabia) market share declined from 43% to 41%.
Source: US Energy Information Agency & Valuewalk.com
As a result, OPEC famously declared economic warfare against U.S. shale producers in a bid to regain market share. Of course, this was accomplished by keeping production levels high as global crude demand began to wane. OPEC hopes to push U.S. producers out of the market once profit losses begin to mount as many U.S. shale producers are not profitable below $60/bbl.
However, this supply/demand story is not the only reason why oil prices have suddenly plunged. There is not that much of a surplus in the market and global demand has not fallen completely out of bed. Global oil prices are denominated in U.S. dollars. As the USD becomes stronger, oil prices decline and vice versa. There is clearly a negative correlation between the two:
So, will oil prices continue to decline? Will it recover any time soon? I honestly don’t know, nor does anybody else. However, the case for a bullish U.S. dollar is a strong one. As other global currencies continue to decline, the dollar will continue to strengthen. Remember, Europe and China (and Japan) are all experiencing slower growth. Additionally, the ECB is planning to launch its own version of QE, which will likely weaken the euro further. The Bank of Japan announced an asset purchase program to boost its economy in November 2014. Meanwhile, the Unites States Dollar continues to gain strength as other global currencies weaken. If this remains, I suspect that oil prices will continue to stay depressed.
This is great news for oil consuming regions (such as the U.S. and Europe), but terrible news for oil producing countries (Saudi Arabia, Russia, Venezuela, Iran, etc.). While the U.S. is a very large oil producing country, the benefits of cheaper oil outweigh the costs. Yes, the sharp decline will likely lead to layoffs for those in the energy sector. However, the sharp gasoline price decline has acted much like a tax credit for those filling up their tanks every week.
The fallout from this crash is tremendous. Outside of the U.S., many oil-producing countries are experiencing a major slowdown (Russia, Iran, and Venezuela depend on oil from anywhere between 68% to 95% of their revenue). What’s worse is that these countries have no choice but to increase production, which will make the situation worsen. Revenue is equal to price times quantity. If the price has declined, then these countries are forced to produce more oil in an attempt to increase their revenue.
Another side-effect that has occurred is here in the U.S.. A lot of shale oil producers are loaded with debt. This wasn’t a problem when oil prices were higher and producers were cash flow positive. However, now that many of these producers are realizing profit losses, the likelihood that these firms go bankrupt has increased. This means that shareholders and bondholders are at an increased risk. A great example of this exposure is the high yield (junk) bond market. 16% of the junk bond market is comprised of U.S. energy producers. As a result, the high yield bond index underperformed in Q4 2014. A lot of investors got blindsided by this. Many bondholders were concerned about duration risk (interest rate sensitivity). As a result, they held bonds that had a lower duration, but at an unintended cost. Many bond portfolios held a higher level of credit risk. As I mentioned earlier, we live in a global economy where every market action has an equal, but opposite reaction.
While many may not believe it, it truly is a great time to be an American. The dollar is strengthening, unemployment is declining, gas is cheap, and U.S. companies are expected to exceed their earnings estimates. The U.S. economy looks great, but it is at risk by the global slowdown. Oil prices have declined sharply, but this is currently a net positive for U.S. consumers.
So, bottom line? Wear your American shirt with pride, buy a gas guzzling (yet non-polluting) American car (but not on credit), and drive fast to your new high-paying American job. Life is good here in the U.S.A.
- Ryan Hughes, Bull Oak Capital, Bull Oak Newsletter – 1/22/2014
Ryan Hughes is the Founder and Portfolio Manager at Bull Oak Capital. The Bull Oak investment strategy was developed by Ryan Hughes and top UCLA Anderson academics. After working at Merrill Lynch & Morgan Stanley, Ryan wanted to offer a better investment management solution for his clients. Bull Oak was created to provide sophisticated planning and investment management services to successful individuals. Learn more about the firm by visiting www.bulloakcapital.com.
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