The key to global stock markets is the U.S. dollar and U.S. interest rates. We have all seen U.S. interest rates rise, and that is potentially difficult for developed and emerging markets. Developed markets will be impacted as yield instruments become more competitive compared to stocks. Emerging markets will have to watch out; with interest rates in the U.S. rising, the current gap between emerging-market and U.S. interest rates might narrow.
Emerging markets fell between 2013 and 2015 due to lower exports, especially the exports of commodities, not because U.S. rates rose in 2013 and fell in 2014 and 2015. Not only did interest rates rise and then fall in the U.S., but much more importantly, emerging market exports to China fell, and then fell some more as China ended their massive accumulation of copper, metallurgical coal, iron ore, and many other commodities.
The risk of higher interest rates still exists for developing countries, but it is greatly lessened due to the pick-up in demand for the commodities exported by the emerging world. The rate increase mentioned above was accompanied by a big drop in commodity demand; that’s not the case this time, so while the EM will possibly be inconvenienced by higher U.S. rates, the effect will be much weaker than it was from 2013 to 2015.
Currently, China is once again accumulating commodities, and China’s imports of copper, iron ore, and coal are once again picking up. As with developed countries, emerging markets will be impacted by higher interest rates, but they will be affected much less than they were during the last episode.
U.S. Economy and Markets
We see four problems and four solutions for the U.S. economy going ahead.
1. Higher interest rates. Not yet a real problem — more of a perceived problem that market participants are reminded about frequently. Normal economic activity will allow rates to move from the very low manipulated rates caused by central bank purchases of bonds (QE) to a more market-oriented and normal rate. This will allow savers and financial institutions to have some return on money invested in loans, bonds, or other income-yielding investments. Good for bank and financial stocks.
2. Slow and falling U.S. GDP growth, and consequently falling corporate profit growth in the U.S. — a change to encouraging new business will be helpful. Corporate profits are the mother’s milk of stock-market valuations, and GDP growth or export growth are the necessary prerequisites for corporate profits to grow. GDP growth will recover if instead of raising taxes and raising bureaucratic obstacles to formation of new small business, the U.S. embraces a policy of less bureaucracy and more encouragement for this sector.
Businesses with less than 100 employees have created all the net new jobs in the U.S. over the last several decades.
3. The continuing rise of the U.S. dollar versus the currencies of our trading partners will slow economic growth: bad for U.S. exporters of goods and services, and good for U.S. importers.
4. Long-term economic growth has been slow for years since the end of the recession. It is time to reverse this trend, and move from the slowest economic growth for decades to a more normal rate of GDP growth via fiscal policy.
The world economy has been saved from a major recession/depression over the last seven years by massive infusion of quantitative easing (QE) from many central banks into world bond markets. In the U.S., that medicine is not taking the patient to new levels of recovery. The patient is stable but improving at a very slow rate. We suggest that wise fiscal policy be employed to further U.S. economic growth. Tax cuts and wise infrastructure spending (on modernizing the economy) will solve the problem. Tax increases and unwise or wasteful infrastructure spending will not.
The big investment shift that is coming will be to commodities and other real assets.
For years, markets have been worrying about deflation — and as a result, massive QE has taken place in numerous countries. Until recently, inflation has been hard to find for more than a few months in much of the world, and fear of deflation has driven bond yields to zero in a number of European countries and to new lows elsewhere.
We note that globally, the prices of real assets (by which we mean commodities and collectibles) are at multi-decade lows when compared to financial assets (bonds and stocks). To put it another way, commodities have fallen in value, while stocks and bonds have risen.
History tells us several things about commodities and collectibles.
1. They benefit from economic need for monetary tightening. Tightening is often a result of stronger economic growth, but it can be (as it has been recently) due to loosening that has gone too far. Some analysts point out that there is about an 80% correlation between higher Fed Funds rates in the U.S. and positive commodity price performance relative to financial assets for the last 65 years.
2. Commodities and collectibles are correlated with a rise in inflation, and inflation is rising in many countries — especially those who have tried to lower their currencies to export more in this highly competitive world economy.
3. If the current global conversation pressing for more fiscal stimulus in many countries is turned into action, a good part of the stimulus will be infrastructure projects which consume large quantities of commodities.
Inflation Notes: the U.S.
1. Saudi Arabia and others are reversing strategies, and propose cutting production of oil. U.S. gasoline prices are already rising.
2. Health care costs under the Affordable Care Act are rising fast: an average of 25% in 2017.
3. Labor costs are rising as unemployment has fallen to 5%.
4. Owners’ equivalent rent is rising.
5. Current inflation data: The CPI-U (for all urban consumers) was 1.5% in September including food and energy. Ex food and energy (core CPI) was 2.2%.
For the above reasons we are bullish on gold, silver, and oil over the intermediate and longer term.
With the exception of the UK, we are not bullish on Europe. (If you buy UK stocks, hedge the currency.) A series of problems awaits Europe. The disharmony caused by elections in Italy and Spain and continued dislike for the EU by political groups in several European countries will keep the level of concern high.
As we have been stating for months, the emerging markets will do better than the developed markets. We believe that this will continue. Focus on Brazil.