By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
Amid a third summer slowdown and the threat of a European Union breakup, macroeconomic conditions across the globe are flashing warning signs. While five years ago the crisis blew up fairly rapidly in the form of a full-fledged meltdown, the question in 2012 is whether a recession is likely on a worldwide basis.
The developed world has been in a slow growth mode since the Great Recession ended after 18 months, propped up first by fiscal stimulus and then by monetary stimulus that unleashed a flood of liquidity across the financial landscape. For the past two years, the U.S. economy looked like it was coming out of the woods in the late winter and early spring months, as economic activity picked up, joblessness waned and consumer and business confidence grew. But by late spring and early summer both in 2011 and 2012, economic indicators wavered and a fresh outbreak of sovereign debt and financial problems in Europe turned the economic breakout tepid.
Meanwhile, even the strongest economies in Europe haven’t been able to withstand the damage caused by the economic recessions and depressions among the peripheral countries that are having the largest problems with sovereign and financial system debt: Portugal, Italy, Ireland, Greece and Spain. And Germany, France and England are either already in or are slipping into recession as demand moderates.
Emerging markets aren’t unscathed. China cut rates a few weeks ago to stimulate internal economic demand amid slowing growth, while other developing market economic powerhouses such as Brazil and India struggle with flagging growth.
With so many economies across the world experiencing slow growth or outright recession, and major uncertainties facing markets – the European sovereign debt and banking crisis and the U.S. elections, for starters – it’s no wonder equity markets are volatile. Fortunately, amid the gloom there’s good news. Economic growth, albeit on a reduced scale, is still the word of the day in the U.S. and most emerging market countries. And low global inflation and moderating commodity prices provide the global economy with some wiggle room, and even potential headwinds, should growth start to perk up again.
So this month, we’ll look at the factors driving – or perhaps hindering – global economic growth, how those factors reinforce each other in terms of economic correlations and what that means for the markets. We’ll offer some food for thought on how to evaluate economic data in this context over the next few months and discuss what it means for investors going forward.
After positive signs in the late winter and early spring, there are signals that the U.S. economy is slowing. U.S. retail sales slid in May for the second consecutive month, it was reported in mid-June. Economists believe that relatively high unemployment rates and a consistently weak housing market are holding back consumer spending (fig. 1).
Also in mid-June, the National Federation of Independent Businesses’ small business optimism index fell 0.1 point, indicating that small business owners don’t expect economic activity to increase from current levels. While more small business owners expressed confidence about current economic conditions, more are concerned about demand in the future.
The Commerce Department reported that U.S. business inventories rose in April, meaning that more companies were holding inventories in warehouses due to lackluster sales. A buildup in inventory contributed to an overall increase in business activity late last year. Currently, it doesn’t look as if businesses will seek to expand inventories in the near future.
Positives for the U.S. economy include falling gasoline and commodity prices, which provide more disposable income for consumers and businesses to spend. Oil prices fell to a near-term low of $83.32 in futures trading in New York. In fact, oil prices are 20 percent off their highs for the year, granting consumers considerable relief at the pump. AAA reported average gas prices in the U.S. at $3.54 a gallon in mid-June, down from $3.73 in May (fig. 2). This has translated to a drop in wholesale prices, which showed a large drop in May, the biggest since July 2011. Prices for food, raw materials, semi-finished goods and imported goods are also falling – all good news in terms of inflation, which should remain low for at least the near term.
Overall, the U.S. growth picture is positive but not robust. In April, the International Monetary Fund projected U.S. GDP growth at 2.1 percent for 2012 and a slightly higher 2.4 percent growth rate for 2013. The U.S. Federal Reserve is more optimistic about GDP, projecting a 2.5 percent increase this year and next year, although it did trim that forecast from 3 percent in April.
While problems in Europe, relatively high unemployment and uncertainties surrounding the upcoming presidential election, budget deficit and tax increase issues definitely present downside risks, the U.S. economy is showing some resilience in its ability to keep growing, albeit at a modest pace. The Fed’s promise to keep short term and long-term interest rates as low as possible through 2014 does provide some certainty, at least in terms of interest rates, and encourages both consumer and business borrowing. In addition, the Fed has said that if conditions deteriorate, it will consider embarking on further efforts to stimulate the economy via a third round of quantitative easing or other policies.
Spain, one of the larger economies in Europe, cried uncle earlier this month and requested a bailout loan for its banks. While the details of the $125 billion bailout haven’t been officially nailed down, the hope is that the fresh capital will allow Spanish banks to write off toxic real estate loans and return to health, avoiding a larger bailout down the road.
However, Spanish yields are still relatively high. On June 18, the 10-year yield was 7.12 percent, fueling investors’ fears that the country may need a full-scale bailout along the lines of Greece (fig. 3). That would present a daunting task to Europe, as the Spanish economy is Europe’s fourth largest – larger than Greece, Portugal and Italy combined.
The second Greek election in the past month established the course of continued austerity in Greece. We continue to believe that the worst is yet to come for Greece. The troubled nation still faces a mountain of sovereign debt that must be repaid in a currency (the euro) that it cannot depreciate along with strict budgetary rules it must follow. To meet these budgetary constraints, Greece must continue to eliminate government jobs and reduce government pension payouts all the while increasing the taxes levied on its citizens. Thus far, the story in Greece has been a tragic one. Sadly, we believe that these austerity measures are “too little, too late” for Greece. Debt repudiation and a possible exit from the eurozone seem to be increasingly likely. This course of events is likely to spark widespread economic turmoil in Europe and around the globe, should it occur.
Economic news in the rest of Europe isn’t very encouraging. Overall unemployment in the eurozone is 11 percent, a record for the bloc although in line with expectations of mainstream economists. The bloc’s purchasing managers’ index fell again in May, hitting a three-year low. While Germany has largely escaped an economic downturn, signs in June pointed to a slowdown, with a 2.2 percent decline in industrial output in May.
Other larger mainline European countries haven’t fared as well as Germany. The Bank of France reported in mid-June that it expects the nation’s economy to contract in the second quarter following declines in major business activity indexes. In the U.K., a recession appears imminent, as manufacturing purchasing manager activity hit a three-year low in May.
Emerging market economies have been the bright spot in the global economic picture since the financial crisis began. Unencumbered by debt and bolstered by a growing consumer base, emerging markets have powered growth worldwide. Emerging market GDP grew by 7.4 percent in 2010 and by 6.1 percent in 2011. Due to spreading concerns from Europe, growth is expected to hit a bump this year and in 2013 and then resume an upward path in 2014.
Some economists fear an economic bubble in China, fueled by government spending on infrastructure and low yields for savers, a notion that has pushed more investment into the real estate sector. Lately, economic data from China hasn’t been as strong as it was previously, with industrial production growth moving off lows in April while the purchasing managers index fell in May. In response, the Chinese government cut interest rates to spur investment and announced other initiatives to encourage growth, including targeted tax cuts, incentives for the purchase of energy efficient household appliances and fast-tracking of spending for investment projects. On a positive note, along with the rest of the world, the pace of consumer price growth slowed in China, which is an encouraging sign regarding inflation.
India, another large emerging market economy is also experiencing slowing growth. GDP grew 5.3 percent in the second quarter, the slowest pace in nine years. Declining manufacturing output contributed to slower growth. Manufacturing actually contracted by 0.3 percent during that period, and agriculture, a major employment sector, grew by only 1.7 percent compared with 7.5 percent from the previous year. India’s economy is dogged by persistent inflation stoked by entitlement programs and oil imports.
In Brazil, the story is similar. The country’s GDP grew at an anemic 0.2 percent, the slowest pace in two years, led by weak industrial production. Investment also declined during that period, signaling that companies are treading cautiously given global economic uncertainty. The country’s GDP is expected to grow between 2.5 and 3 percent for the rest of the year. One bright spot is consumer spending, which has been bolstered by low unemployment and salary increases.
Emerging economies in Europe – including Turkey, Russia, Poland and Hungary – tend to be more affected by economic events in the core of Europe. Russia is holding up fairly well, as manufacturing gained momentum while purchasing managers’ indexes in Turkey and Poland declined. Hungary, however, bucked the trend with an upturn in PMI in May, rising significantly over April.
Overall, putting the pieces together reveals a global economy that is slowing, although not dramatically over recent growth rates. In a mid-June report entitled Global Economic Prospects: Managing Growth in a Volatile World, the World Bank noted that many challenges face the global economy. While emerging market growth is fairly steady, these economies aren’t as insulated as they could be from trouble in developed countries, which could impact growth prospects across the globe.
World Bank’s report noted that many of the issues plaguing Europe and the developed world – including sovereign debt loads, struggling banks and resulting volatile markets – are overhangs from the financial crisis. In a troubling sign, the Bank of International Settlements reported that global lending is contracting at the fastest pace since the 2008 Lehman Brothers crisis. Implementation of Basel III regulations means that European banks must have a higher level of core capital, so fewer funds are available for lending.
The World Bank predicts that GDP in developing countries will grow by 5.3 percent this year and won’t hit 6 percent growth in either of the next two years, falling short of previous years. The prediction for global growth this year is at 2.5 percent, with growth picking up to 3 percent in 2013 and 3.3 percent in 2014.
The biggest factor weighing on markets is the situation in the eurozone. Watch Euro-area bond yields. If Spanish and Italian 10-year bond yields remain at or above 6.2 to 6.5 percent, these countries might be unable to tap lending markets to fund government operations, necessitating a large bailout from the eurozone and potentially the International Monetary Fund. The political situation in Greece also bears watching as internal economic instability could pressure political leaders to consider leaving the eurozone. Euro-area ministers also need to move more quickly to diffuse this crisis, as issues that have lingered in the past have contributed to market volatility.
Here in the U.S., employment numbers remain key. Unemployment needs to continue to fall in order for the economy to grow. Also, improvements in retail sales could be an important sign that consumers are regaining the confidence to spend, especially as less of their discretionary income goes to fill their gas tanks. Falling gas prices will also impact consumer prices, giving further support to the thesis that inflation is largely dormant, which tends to increase both consumer and business confidence.
Keep an eye on U.S. initial jobless claims. As this commentary goes to press, initial jobless claims are sitting at 386,000. Watch for trends in this weekly economic series. A downward trend would signal a strengthening domestic labor market.
Uncertainty seems to be the name of the game. Economic, political, fiscal and monetary policy uncertainties are contributing to volatility not just in the equity markets but in the bond and commodity markets as well. Are we going to see a breakup of the eurozone? Will the Chinese growth story end? How will the U.S. elections turn out? What’s going to happen with the fiscal cliff? How long can the U.S. continue to run $1.2 trillion dollar deficits? These are just a few of the questions at the forefront of investors’ minds.
Investors will do well to be mindful of all the present risks. However, grave mistakes are made when investors get caught up in the emotion of negative headlines and doomsday forecasts and make rash selling decisions out of risk assets at precisely the wrong time. Historically, these times have been some of the best entry points into risk assets. The world has a habit of continuing to turn, and societies are rarely wiped from the face of the earth. So when it looks like everything is going to come apart and the markets are in a freefall, investors should think twice before selling the farm.
Looking forward, it seems the only thing that is certain is uncertainty. Uncertainty produces volatility, usually without any clear trends. In these environments, more frequent rebalancing may lead to better results for investors and may also present more entry point opportunities for cash sitting on the sidelines.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The European Union (EU) is an economic and political union of 27 member states which are located primarily in Europe.
The National Federation of Independent Business (NFIB) is a nonprofit, nonpartisan organization representing small and independent businesses. NFIB represents the consensus views of its members in Washington and all 50 state capitals.
The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.
The World Bank is an international financial institution that provides loans to developing countries for capital programs. It is made up of two unique development institutions owned by 187 member countries: the International Bank for Reconstruction and Development (IBRD) aims to reduce poverty in middle-income and creditworthy poorer countries, while the International Development Association (IDA) focuses on the world’s poorest countries.
The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.
Basel III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11.