Fixed Income Outlook October 2015: Is China Really That Important?
Negative sentiment permeated the stock and bond markets this quarter, with August taking September’s usual honor as the worst month of the year, so far, for stocks. In particular, concerns about China weighed on the markets, and the Federal Reserve (Fed) Governors fanned these fears with comments at the September Federal Open Market Committee (FOMC) meeting, when they voted to hold the federal funds rate steady. What could have been a routine statement, citing the moderate pace of growth in U.S. economic activity, job gains and improving unemployment, was turned on its side when the Fed mentioned that “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” So now it seems that non-U.S. economic concerns are also driving Fed decisions. But the real question is: If U.S. economic activity is improving and commodity inflation is low (albeit due to China), why is that bad for the U.S.? Do China, Greece and other emerging markets really impede U.S. growth and are they really part of the Fed’s dual mandate of price stability and full employment? The issue the markets are trying to digest is: What will ultimately drive the Fed to begin interest rate normalization? Given continued drops in unemployment and growth in Gross Domestic Product (GDP), market participants could be forgiven for thinking foreign issues should not be the Fed’s concern. But now, instead of welcoming the first step towards interest rate normalization and waiting for the rest of the world to catch up to our strength, investors were pushed by the Fed’s statement to sell riskier assets out of concern that weakness in non-U.S. markets will eventually infect us. The latest FOMC statement seems to have altered market psychology by emphasizing these external factors that should matter little to the U.S. market. Traders have been rightfully nonplussed, as evidenced by the recent selloff. However, it appears to us that such knee-jerk reactions may be overdone.
While issues abroad may cause short-term volatility, we believe they should not derail the U.S. economy. The key during times like these is to maintain a focus on U.S. fundamentals and not get caught up in emotion. As we saw, the Greek near-default and continued austerity have been a non-event for the U.S., economically-speaking, since much of Greece’s debt is held by the International Monetary Fund (IMF) and other European governmental institutions. Looking at China, its stock market collapse also appears to have little contagion risk as most global investors viewed its rise as a localized bubble. China is a nation of savers. Despite having a 50% savings rate, many ordinary citizens do not invest in the stock market, so the recent correction had little real impact on them. Recent weakness in emerging markets seems to have been driven more by China’s big downturn in commodity demand and its recent currency manipulation.
China’s recent ascendancy to the world’s number two economy has made it the largest contributor to global growth. That growth, however, has been largely based on government-supported infrastructure and a private property boom, which were both unsustainable in the long term. During the growth years China became the largest buyer of many raw materials and suppliers around the world built up infrastructure to feed this demand. These suppliers became China’s co-dependent partners in growth. As long as the U.S. dollar was weak and Chinese demand was high, this worked out well. Commodity prices saw a big increase during China’s economic boom and, not surprisingly, have lately seen a sharp reversal. For producers of commodities, especially those who expanded capacity using debt, this reversal may be a painful and disruptive process which may take many years. That said, the U.S. economy is not negatively impacted by falling commodity prices and we think China’s issues will most directly affect China itself and their suppliers, mostly in emerging markets.
Another consideration is that China’s transformation was largely built on debt. As a share of GDP, China’s debt load in 2014 stood at about 280%, an increase of about 80% since 2007. Basic economics teaches us that a rapid increase in national debt is the most reliable predictor of future economic slowdowns and financial crises. Therefore, it’s no surprise that a shift from an investment- and export-led economy to a more domestic consumer driven one (which typically creates fewer jobs) will likely cause a decline in overall GDP growth and aggregate consumer income.
Chinese leaders have clearly warned that their economy needs to accommodate a “new normal” of slower growth. Now the rest of the world needs to reset to this “new normal” as well. For the U.S. however, this phase may prove to be an economic tailwind. China accounts for about 20% of U.S. imports of goods and services and only about 1% of U.S. exports (which explains China’s huge trade surplus). The recent modest devaluation of the yuan is a net positive, as lower import prices from China should help stretch U.S. consumer buying power over time. The U.S. consumer currently represents about 68% of U.S. GDP. While a stronger dollar will negatively affect some emerging markets, U.S. multinational companies may also see a marginal negative impact on their financials as they translate foreign earnings back into dollars.
With commodity prices falling back to more normal historical levels, it seems the seeds are sown for low inflation and slower global growth. This may have played into the Fed’s thinking about interest rates, but they could have articulated their thinking more clearly. As we stated above, the sentiment of the market has suddenly changed from optimism to pessimism. Time will tell which path we are truly on.
The Fed has two more meetings this year, in October and December. For a number of reasons we are skeptical that they will use either meeting to raise the benchmark rate. First, the global cloud of uncertainty will not disappear in the near term as China’s slowing growth ripples across the world. It will likely be many years before we see healthy growth return to the region. Second, low inflation in the U.S. is likely, in our view, to persist for a while. The strong U.S. dollar has put downward pressure on import prices, which is at odds with the Fed’s efforts to buoy inflation. Lower commodity prices, especially oil, have also lowered consumer and manufacturing raw material prices. These prices may stay low as supply seems to be outgrowing demand. In addition, although the yuan has recovered somewhat from its August lows, China is still exporting deflation. On the flip side, we don’t think the large impact that declining energy prices had on our inflation in late 2014 and so far this year will be repeated next year. In fact, we think energy may be slightly inflationary in 2016, giving the Fed a much needed future window to initiate rate normalization.
In the end, rates should eventually rise. Our economy is no longer in the emergency room and drastic heroic monetary stimulus is no longer needed. The Fed must know that waiting too long to raise rates has risks. The longer they wait, the more difficult it will be. This is partly due to the possibility that inflation picks up next year due to the basing effect of commodity prices. Additionally, the U.S. unemployment rate, having already fallen from 10% in 2009 to 5% in August 2015, appears likely to drop further. As the unemployment rate falls and if aggregate wages ultimately rise, this too, could act as a tailwind for rising inflation. This could leave the Fed playing catch-up, raising rates faster and higher than the measured pace the market anticipates. Unfortunately, the Fed has historically been reactive versus pre-emptive – so it seems that they may be preparing to continue this long, proud tradition.
In summary, as the world is settling into a “new normal” of slower growth and low interest rates, we expect that returns on fixed income securities may remain low for the foreseeable future. Increased uncertainty about the timing of future rate increases and expected higher volatility driven by general concerns about the global economy lead us to believe that maintaining shorter duration and ample liquidity is the best way to position our clients, regardless of when or if the Fed decides to start raising rates. Our aim is to achieve income and moderate capital appreciation while attempting to minimize the negative impact of volatile markets. Additionally, we can hopefully take advantage of periods of market weakness to acquire bonds at what we view as attractive yields. During the recent pullback in the equity market, we are also seeing value in some convertible bonds and hope to increase our holdings in that asset class to some degree as well.
As always, we thank you for your continued trust in us and welcome any questions and comments.
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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© Osterweis Capital Management
© Osterweis Capital Management