by Thomas Dillman
While the United States economy remains solid, the financial markets continue to move dramatically in both directions, affected by a variety of domestic and global issues. Mutual of America Capital Management LLC takes a close look at some of these issues, including rising interest rates in the U.S., increasing oil prices and a stronger dollar, as well as ongoing global tensions on trade and the recent elections in Italy favoring a group opposed to the European Union.
The global synchronized economic recovery of 2017 has become less synchronized. Europe slowed, Japan plateaued and China is in the process of managing a slowdown by means of restraints on credit creation. Emerging markets are struggling with financing dollar-denominated debt as the dollar is strengthening. Turkey, Brazil, Argentina, Venezuela and, most recently, Italy are all in financial and social crisis.
The U.S. economy, however, remains economically solid and in growth mode. Gross Domestic Product (GDP) averaged 2.5% over the past year, well above the expansion average of 2.0%. GDP in the first quarter of 2018 was a weak 2.2%, though only 0.1% lower than expected. Estimates for annualized quarterly GDP for the remainder of the year are all higher. Supporting strong overall growth, measures of industrial production and capital investment are rising at an accelerating rate, offsetting consumer spending weakness and modest housing growth.
Further evidence of economic health is an unemployment rate of 3.8%, one of two monthly readings below 4.0% over the past 30 years. The most recent job report for May was surprisingly strong, and average hourly earnings came in at 2.7% year-over-year, near its January cycle peak. At the same time, inflation as measured by the Personal Consumption Expenditures Price Index, or PCE, recently reached the minimum 2.0% level targeted by the Federal Reserve (the "Fed"). The Consumer Price Index (CPI) recently accelerated to a rate of 2.5%, but largely as the result of a year over year spike in energy prices. The "core" indexes for both measures, which exclude the volatile food and energy components, are currently at or below the target. Finally, corporate profits for the first quarter of 2018 were extremely strong and above expectations, even excluding the effect of tax cuts. Profit margins hit historical peaks last seen in the 1950s.
But markets are driven by expectations about the future, not current conditions. Over the past several months, a number of troublesome trends have developed. First, interest rates are rising, reducing affordability for prospective home buyers, reducing spreads on bank loans, raising costs for borrowers with variable rate debt and raising the cost of new bond issuance by the U.S. Treasury Department. In the latter case, the effect over time is to increase annual deficits and the national debt. Second, oil prices rose from $55 per barrel to $70 per barrel over the past six months, translating into higher gasoline prices. Higher gas prices are effectively a flat tax on consumers, thus hurting those with less income disproportionately and offsetting most, if not all, of the benefit of tax cuts. Finally, the recent strengthening of the U.S. dollar increases the cost of imports for foreign buyers of dollar-denominated goods, the most significant of which is oil. Dollar strength is particularly worrisome for emerging markets with high amounts of dollar-denominated debt, both public and corporate, and/or those dependent on imported oil. A strong dollar also poses a challenge for U.S. growth because it fosters expansion of imports and reduces exports, thereby increasing our trade deficit and reducing GDP.
Potential Impact of Interest Rates
The drivers of each of these variables are known. In the case of interest rates, the Fed has raised the Fed funds rate for the past two-plus years, driving longer-term rates higher as a result. The rise in the price of oil is the result of an agreement between OPEC (primarily Saudi Arabia) and Russia to control the marginal supply of oil to world markets and, thereby, drive up the price. The rise in the dollar is a function of the greater relative strength of U.S. growth and the attractiveness of higher relative interest rates versus other developed countries in Europe as well as Japan.
However, the impact on growth of rising rates, oil prices and the dollar, while clearly negative in the long run, is likely supportable over the next year. The Fed is moving cautiously and can stop or reverse its course if growth starts to deteriorate. Modestly rising oil prices are sustainable as long as demand remains strong. When any currency strengthens, other currencies weaken in a floating-exchange-rate world, which applies among developed economies. However, in this latter case, economies with fixed exchange rates (e.g., emerging markets) may ultimately be forced to unilaterally devalue their currencies, thereby creating global financial instability. Finally, the interaction of these factors and their differential impact on individual economies is impossible to forecast with any degree of confidence. As noted in previous issues of Economic Perspective, markets loathe such uncertainty.
Continuing concerns for markets include the pace of rate increases from the Fed and the trajectory of global trade. Economists are debating whether the Fed will institute either three or four rate increases this year, and market indicators can be used to determine the probabilities of one outcome versus the other at any given point in time. Of course, the probabilities fluctuate in response to public comments by Fed members, as well as the flow of news affecting economic growth. What the Fed ultimately decides will be determined by its interpretation of data through time.
Changing Face of Global Trade
As for global trade, President Trump's various initiatives continue to make waves, starting with his abrupt withdrawal of the United States from the Trans-Pacific Partnership (TPP) and his insistence on renegotiating the North American Free Trade Agreement (NAFTA) with Mexico and Canada, as well as the bilateral trade pact with South Korea. More recently, he announced a 25% tariff on all steel imports and a 10% tariff on all aluminum imports, as well as the intention of the U.S. to institute $50 billion worth of tariffs on unspecified Chinese goods. Trump has made it clear since the presidential campaign that he would seek what he called "fair trade" as opposed to "free trade," pointing to the U.S. trade deficit as evidence. On this basis, he has exercised his authority to set trade policy in the name of national security.
However, the implementation of these initiatives is indecisive and confusing. First, changes in the U.S. treaty with South Korea were largely cosmetic. Second, the NAFTA negotiations have dragged on for over a year. Intermittent reports suggested the parties were close to agreement, and then were contradicted by other reports that major differences remained. In any case, the President's campaign threat of a quick withdrawal from NAFTA by the U.S. if its terms were not met has failed to materialize. In addition, he agreed to grant extensions of the deadline for implementing the steel and aluminum tariffs to most U.S. allies, but not to China. And immediately following his threat to impose huge tariffs on China, to which China responded in kind, the two countries began to engage in ostensibly serious negotiations to come to agreement on adjusting the terms of trade between them. However, one of the most recent news items on trade from the White House is that the $50 billion of tariffs on Chinese goods would be implemented. Finally, the U.S. decided to impose the original steel and aluminum tariffs on those countries—mainly U.S. allies—that were granted initial extensions.
Many commentators have likened Mr. Trump's trade tactics to his business methods, beginning any deal with huge demands only to soften his approach as negotiations proceed. However, international trade is much more complex and sophisticated than a real estate deal and has much wider economic and social consequences. It is not a stretch to say that the current U.S. approach to trade issues has created confusion, turmoil and uncertainty about whether the strides made in opening up global trade since the founding of the World Trade Organization (WTO) in 2000 will be stopped, or even reversed. Free trade has fostered growth and kept a lid on inflation. Shaking the foundation of the system with vacillating and contradictory policy announcements threatens the benefits gained from more open trade. Admittedly, the free trade agenda has caused dislocations, especially for workers in those businesses that have moved to other countries. But in many commentators' opinions, the benefits have outweighed the costs. The trade issue remains a major concern for investors as well as policy makers throughout the world.
Italy the Next "Brexit"?
The newest concerns for markets are the potential consequences of the recent elections in Italy. The winning Five Star Movement strongly advocates withdrawing Italy from the European Union (EU), thus threatening the viability, if not existence, of the euro, one of the three major currencies supporting the international trade and financial system. Italy's possible defection is far more serious than the threat by Greece of leaving during the period between 2009 and 2012. The European Central Bank (ECB) stepped in to eventually quell that crisis, with Mario Draghi, its president, famously claiming the ECB would do "whatever is necessary" to save the euro and maintain the EU. However, Italy is not Greece. Italy is the fourth largest economy in the EU (whereas Greece is 15th of 28) and also the largest debtor. If Italy were to officially withdraw, the country would essentially be bankrupt because it would be unable to refinance, let alone pay off, its debts. The ripple effect of such a massive default is almost unimaginable.
It is far too early to forecast how this issue will play out. At this stage, the crisis revolves around which party, or coalition of parties, will control the Italian parliament. While the Five Star Movement won the most seats, it did not receive a clear majority, thus requiring it to form a coalition government. Up until recently, such efforts had failed, threatening the need for new elections within the next several months. Such an election would have been viewed as a referendum on the sustainability of the euro and the European Union, and the least attractive alternative path to a solution. However, through a number of compromises with the current president of Italy, the Five Star Movement was permitted to form a new coalition government with the far right League party. What can be confidently asserted is that any resolution of the situation will take a long time, during which there will be many twists and turns (see: Brexit). In addition, it appears highly likely that markets will experience more volatility than over the past year and a half if recent dramatic swings in stock prices and interest rates around the world are any indication.
It is becoming more difficult to remain bullish about stocks in the near term. The obstacles facing a substantial upside in the financial markets seem to be piling up. With all the macro distractions, it is hard to focus on the underlying health of the domestic and international economies. Ultimately, growth must sustain markets. At this point, the U.S. economy continues to grow at a solid pace. The question is whether that path can be maintained in the face of slowing economies abroad, potential trade wars, rising interest rates, high oil prices, a stronger dollar and another crisis in Europe. We are not calling for a recession any time soon, but the odds are surely rising. That said, above-average, long-term investment returns are rarely achieved by attempting to time the ups and downs of the market. The best investors tend to hold portfolios that are consistent with their risk tolerance and long-term return expectations.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.