Economic Discussion A Review of the Economy and Financial Markets

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1 Economic Discussion A The Economy and Politics Last month we talked about uncertainties in Ukraine and Greece. Those situations inched toward resolution in recent weeks, but are far from resolved. A cease fire was agreed upon in Ukraine which was to have begun February 14 th. On the 25 th it may have started to take hold. News reports don t indicate how much ground was gained or lost in those ten days. It would be interesting to know. The newly elected Greek government, after some saber rattling, appears ready to make concessions in order to get debt service deadlines extended. The economies of both nations are suffering. Ukraine is suffering great loss of life and property as war has raged in its eastern region. In addition Russia has a stranglehold on them because of Ukraine s dependence on Russian energy supplies. The Greek economy had suffered six successive years of declining economic activity before turning slightly positive (0.75%) in Ironically, the Greek people appear to have rejected austerity just as the benefits were about to accrue. Greece and the European nations that have lent it money are discussing an extension on debt payments. Some Greek officials have suggested that they might not be able to make a payment due to the International Monetary Fund (IMF) in March. At the same time some officials have said that government paid salaries and pensions weren t at risk. The final outcome of this situation is not clear. Greece leaving the Euro Currency compact is still a possibility. The economic impact of such an event is probably not disastrous beyond the Greek people and the country s creditors because Greece s economy is small. The nation s experience should, however, serve as a warning to other, larger countries. Greece has financed pensions and government workers salaries by running fiscal deficits and borrowing to pay the bills. Its government debt is now 169% of GDP. Lenders are reluctant to continue renewing its debt and the interest they demand is high. The populace is angry because of broken promises and the threat of higher taxes. There is not an easy solution to the problem and the Greek people will suffer regardless of the remedy. In the developed world, economies are struggling to grow. In a recent Wall Street Journal guest editorial, former U.S. Treasury Secretary Robert Rubin asserted that there is too much reliance on monetary policy to solve financial woes in Europe, Japan and the U.S. Expansive monetary policies, known as quantitative easing (QE) have been pursued in all three regions. The results have been less than stellar. Mr. Rubin warns that imbalances caused by extremely low interest rates can lead to economic instability. He says, Monetary policy is important, but not omnipotent. The relentless focus on monetary policy creates serious moral hazard by taking attention away from elected officials failure to act on the fiscal, public investment and structural issues that are the key to short- and long-term economic success. 1 These thoughts echo those you have heard in previous issues of this newsletter. We have oft stated that monetary policy alone cannot support a healthy economy without sound fiscal policy. We suspect that Mr. Rubin and this writer would differ on particular aspects of good fiscal policy, but he and I are in agreement on the limitations of monetary policy. The, presented by Chemical Bank, is a publication based on resources such as statistical services and industry communications which we believe to be reliable but are not represented as accurate or complete and therefore cannot be guaranteed. Any opinions expressed in this publication may change at any time without notice. Based upon varying considerations, the management of individual accounts by Chemical Bank may differ from any recommendations herein. This report is provided for informational purposes only and does not constitute a recommendation to purchase or sell any security or commodity.

2 Fiscal changes should include tax reform that simplifies the tax code by removing preferences and reducing government spending to balance the budget. These steps would return the U.S. economy to a growth path more like its historical pattern. The U.S. economy continues to grow in a slow and inconsistent manner. Growth in the fourth quarter of 2014 (Q4 14) was revised to 2.2% (annual rate) from the initially reported 2.6%. Chart I, which follows, shows the pattern for the past fifteen years. The February employment report, released March 6 th, was positive. There were 295,000 new jobs created and the unemployment rate dropped to 5.5% from 5.7%. Growth for all of 2015 is likely to be 2.75%. That s lower than most forecasts, but our experience has been that early forecasts are often optimistic. Inflation is benign and has been driven down by falling energy prices as well as other commodities. Through January the year-over-year change in the Consumer Price Index (CPI) was -0.1%. Excluding food and energy (the so-called core measure), inflation was up 1.6%. Inflation in 2015 will probably be about 1.25% including food and energy. Chart I The 2.2% rate is equal to the average since the recovery began in 3Q 09. The inconsistent pattern from quarter to quarter is obvious, as one views the graph. Consensus expectations for 1Q 15 are for 2.50% growth. That may be optimistic if for no other reason than winter weather. Last year s harsh winter is cited for the negative growth in its first quarter. This winter hasn t been as bad, but it has been cold through much of the country. Page 2 The European and Japanese economies are likely to grow at about 1% in Experience in emerging economies will be varied. China will lead the way at 7% with India close behind at 6%. Russia, because of its energy dependence and economic sanctions will contract significantly. 2 Central banks throughout the developed world are concerned about the low level of inflation. There are several reasons that central banks are trying to foster modest inflation. Deflation discourages business investment because money appreciates relative to real assets. Money stuffed in the proverbial mattress appreciates! Also, deflation increases the burden of debt repayment because the obligation is repaid in more expensive funds. Although price stability is the mantra, it appears that a little bit of inflation is good. Exporting economies favor inflation because it cheapens their goods in other currencies. That works fine until everyone does it. We may be getting near the point where currency depreciation is self-defeating. Financial Markets and Interest Rates The U.S. stock markets are near all-time highs. Even at these levels Price-to-Earnings (P/E) ratios are not high by historical standards. The

3 price of the S&P 500 index represents a P/E ratio of 17.1 times estimated 2015 earnings. Its dividend yield is 1.9%. Foreign stocks have not fared so well in recent years as shown in Chart II. Eurozone has been grappling with fiscal crises in several nations, most prominently Greece. Japan, after decades of sluggish growth, stimulated growth in excess of 2% with government stimulus in In the next couple of years their economy is expected to advance at a rate closer to 1%, based on Bloomberg s survey. Slow economic growth has contributed to poor stock performance of foreign stocks, but the relative strength of the U.S. dollar has also been a factor. In Chart III the foreign indices are expressed in U.S. dollar equivalents. The value of the trade-weighted U.S. dollar over the past year is shown in Chart III. Since July, the dollar has been on a persistent, upward course. Chart II The black line is the S&P 500, the red line is the MSCI EAFE index of foreign, developed equities and the gray lined traces the MSCI emerging market index. The large cap indices were neck-and-neck until late 2013, and then the foreign index fell behind. Emerging market stocks were very strong in the first few years, fell further than the developed indices during the recession and then recovered quickly. Since 2010, however, those issues have been essentially flat. In the past two years falling growth rates in emerging markets have depressed stock prices, even though the expected growth rates are much higher than those foreseen for developed economies. Foreign, developed economies have had difficulty generating any growth at all. In Europe, real GDP fell in 2013 and During this time the whole Page 3 Chart III Markets may be reaching a tipping point as European economies start to grow again and as the dollar levels out or even falls. These developments may not be imminent, but investors should be prepared for the change. It is difficult to time such occurrences accurately. On March 6 th U.S. stock prices fell in response to the strong

4 employment report. Pundits attribute the drop to the belief that the good economic report makes it more likely that the Federal Open Market Committee (FOMC) will raise interest rates sooner rather than later. If higher interest rates trump better economic prospects, stocks prices are vulnerable. Valuation measures such as expected earnings growth and P/E ratios indicate that stocks should be over-weight relative to bonds. Considering the risks noted in the foregoing paragraphs, investors could maintain their overall stock position, but gravitate toward less volatile issues. Among the stock classes, valuation indicators favor foreign issues, both developed and emerging. Political considerations in many parts of the world make foreign investments riskier than they might otherwise be. As noted in the first paragraph, the Ukrainian and Greek situations may be moving toward resolution. Investors would be wise to start gravitating back to foreign equities. The media is focused on when the FOMC will begin raising short-term interest rates. Judging from the stock market s reaction to the employment report, perhaps investors are, too. For the last several years, prognosticators have anticipated higher interest rates. Starting in 2008 the FOMC initiated a program of buying long-term securities in order to stimulate the economy by fostering lower interest rates. They kicked off another round in late 2011 and a third in These programs were referred to as QE1, QE2 and QE3. The QE stands for quantitative easing. Chart IV plots the yield of the ten year Treasury note for the past five years. Chart IV It is difficult to see the direct effect of the programs in the chart. It would appear that QE had the desired effect in 2010 and The ten-year yield remained low until mid-2013 when the committee announced that they would begin scaling the program back. Interest rates spiked up on the announcement. They didn t cut back their bond purchases at that time. The actual reduction in monthly purchases was carried out from February 2014 through October Over that period interest rates fell. The point of this discussion is that the FOMC s policy moves are only one of many factors influencing long-term rates and predictions are wrong more often than they are correct. Still, investment decisions must be made and investors need to formulate some kind of rate forecast. The FOMC is likely to move the fed funds rate 2 upward in the last half of 2015 and continue to do so through The FOMC is able to directly control short-term rates because they can control bank reserves. Page 4 Our best guess is that the fed funds will start to increase about mid and reach 0.65% at year end. It would move up another

5 percentage point over the course of The ten-year Treasury yields 2.24% currently. Our most likely case calls for it to be 2.60% at the end of 2015 and 3.40% at the end of Beyond 2016, short-term rates are expected to increase more than long-term rates. If a normal state for interest rates ever returns, the two-year Treasury would likely yield 3.50% and the ten-year 4.75%. 1 The Search for a Monetary-Policy Wizard and Political Moral Hazard, Robert E. Rubin, The Wall Street Journal, February 23, Bloomberg Finance, LP is the source for growth estimates. 2 The fed funds rate is the rate at which banks lend to each other from one business day to the next. Rising interest rates will depress bond prices. Long-term bonds fall more for a given rate increase than short-term bonds. In today s environment, instruments with a term of less than a year yield almost nothing. The most attractive part of the yield curve is from two years to five years. Incremental yield is captured in that range while price volatility is mitigated. Asset Allocation Investors should continue to carry a modest over-weight in stocks. Heretofore, large-cap U.S. stocks have been the best performing class and may continue to perform well. The time is approaching when investors will want to rotate toward foreign stocks, both developed and emerging. U.S. stocks have had a very good run, buoyed by low interest rates and a rising U.S. dollar. Those factors will change. Economies in Europe are showing signs of turning the corner. Investors seem to be adjusting to lower growth expectations from emerging economies. Even though rising interest rates will put downward pressure in bond prices, fixed income investments are a vital part of a well-structured portfolio because they reduce risk and their price movements are not correlated to stocks. The maturity structure of bond portfolios should be concentrated in the two-to-five year area. Cash equivalents yield very little. anticipated liquidity needs. They should be held only for February 7, 2015 wcl Page 5