Fixed Income
A strengthening economy and improving labor market help boost federal budget revenue and lower outlays (along with the automatic spending cuts implemented a few years ago). Federal receipts have risen 43 percent over the 2009 – 2014 period while spending has fallen 0.3 percent. This combination of fiscal restraint and rising revenue as the economy improves has helped shrink the 2014 budget deficit to $485 billion, or 2.8 percent of GDP, from $1.4 trillion, or 9.8 percent of GDP, in 2009, according to the Congressional Budget Office (CBO).
Deficits projected by the CBO in coming years remain large by historical standards, in the range of 2.5 percent to 3 percent of GDP versus an average of 1.9 percent from 1956 through 2007. However, on the margin, the amount of new debt being issued is falling from the extremely high levels of the 2009 – 2011 period as a result of the improved budget position.
As the deficit narrows, the financing needs of the Treasury decline and the amount of new debt issuance dwindles (Chart 5). Net Treasury issuance totaled just under $120 billion in 2007, the year before the Great Recession began. That figure reached $380 billion in 2008, then surged to $1.56 trillion in 2009 and peaked at $1.61 trillion in 2010. Since 2010, net issuance has trailed off to roughly $840 billion in 2013 and 2014.
As the supply of Treasury debt declines, all else being equal, prices should firm somewhat and yields should reflect some downward pressure. This negative influence may offset some of the forces pushing yields upward as Fed policy makers begin the first rate-tightening cycle in nine years. Overall, we still expect Treasury debt yields to rise as the Fed funds target rate moves higher, but the extent of the rise may be somewhat muted due to the falling supply of new issuance.
Commodities
In February 2015, the price ratio of gold to silver spent its fourth consecutive month above the long-term 75th percentile (a ratio of about 71 to 1, or where it would take about 71 ounces of silver to buy an ounce of gold). In May 2015, the ratio sat almost exactly at the 75th percentile of historical ratios (Chart 6).
There have been seven previous occasions since 1976 when the ratio of gold to silver prices has crossed above the 75th percentile for at least four months. In the three most recent (July 1997, March 2003, and January 2009), silver outperformed gold over the subsequent one-, three-, and five-year periods. In six of seven of the previous occasions, silver outperformed gold over the subsequent three-year period.
U.S. Equities
The Standard & Poor’s 500 Index has risen from a closing low of 676.53 on March 9, 2009, to 2,063.11 on June 30, 2015, more than tripling in value. At the same time, corporate after-tax profits as reported by the federal Bureau of Economic Analysis (BEA) rose about 81 percent, and operating profits for companies included in the S&P 500 surged 164 percent. Many factors contributed to rising profits, including subdued growth in compensation costs.
As labor markets continue to improve, compensation costs are likely to accelerate and may have a detrimental effect on profit growth. Historically, there has been an inverse relationship between unit labor costs and profits. When unit labor costs accelerate, profit growth tends to slow, and if those costs rise fast enough, profits can shrink (Chart 7).
In general, there are three ways businesses can deal with rising labor costs. They can try to pass them through to final purchasers by raising prices. If the economy is strong enough and competitive pressures allow, higher prices can sustain compensation increases and higher profits but at the risk of contributing to inflationary pressures.
A second alternative is to find offsetting cost cuts. This approach isn’t always easy and can typically be sustained for only so long. A third way to deal with higher compensation costs is to boost productivity. Growth in real output per hour has been disappointing in this recovery. Explanations for this weakness vary, however. With interest rates low and cash readily available on many corporate balance sheets, there is reason to be optimistic that as rising compensation costs pressure profits, businesses will find ways to boost productivity through increased investment, protecting profit growth.
Global Equities
As British forces surrendered to the allied American and French armies outside of Yorktown, Va., in 1781, the British band played, “The World Turned Upside Down.” That bit of historical irony comes to mind when reviewing the economic conditions and equity market performance around the world.
Looking beyond the U.S. economy and markets, the two most common stories in the financial world are the (still) unfolding drama in Europe with Greece and China’s recent market plunge. Having defaulted on loans to the International Monetary Fund (IMF) and having been declared officially in arrears, Greece faces increased risks to its financial and economic future. As of this writing, in the immediate wake of the Greek vote that demonstrated popular support for rejecting the bailout terms, it is unclear when (or if) negotiations will continue among the IMF, the European Central Bank (ECB), the European Commission (EC), and Greece on future funding, refinancing, reforms, and austerity. Among the many questions is whether Greece will remain in the eurozone and continue to use the euro or resurrect the former national currency, the drachma. It’s not surprising that given the state of Greece’s economy and enormous uncertainty about the nation’s economic and financial future, the Greek equity market has been a very poor performer (Chart 8).
A bit more unexpected may have been the recent sell-off in China, where the Shanghai Composite Index was down close to 35 percent from an all-time high reached on June 12, 2015. Economic expansion has been slowing in China and government officials have been reducing growth targets over the past several years. While the slide in equities may appear small in relation to the gains over the past 10 years, volatility has been substantial. Still, despite the recent declines, Chinese equities have been strong performers, rising more than five-fold since 1995, and second only to Mexico in the chart (Chart 8).
Mexico has been one of the most interesting performers in global equity markets. Though not in the headlines nearly as much as Greece, Europe, or China, Mexico’s IPC index has outperformed the Shanghai Composite, S&P 500, and the Athens benchmark index over the past two decades, climbing to more than 19 times its 1995 average price (Chart 8). It should be noted, however, that if exchange rate movements are considered, Mexico’s IPC index has only risen about seven-fold whereas China’s Shanghai Composite would be up about eight-fold.
The bottom line is that a disciplined investment framework, including global diversification, can help boost portfolio performance. Investors will likely do better with research-based strategies rather than decisions driven by news headlines.
Next/Previous Section:
1. Overview
2. Economy
3. Inflation
4. Policy
5. Investing
6. Pulling It All Together/Appendix