State of the Markets
We are halfway through the year and upward momentum has returned to most major asset classes, even as year-to-date gains are limited to mid-single digits. Bonds added two percent to the first quarter’s gains, resulting in a strong 3.9% return for the first half. Global equity markets delivered strong returns for the quarter as well, putting each of the three major equity asset classes (domestic, international, and emerging) on solid footing for the year. The total returns for major asset classes are below.
The total returns for major asset classes are below.
Whatever concerns investors had earlier in the year seem to have subsided, leaving the reality of high corporate profits, low inflation, and a slowly improving economic landscape. As one prolific market commentator said via Twitter:
“Only reason the market is going up is a gradually improving economy, low rates, solid earnings growth, rising confidence and buybacks. (What a) scam.”
This does not mean the markets are without risk. Stock prices have risen somewhat faster than underlying fundamentals and bonds still trade at historically low yields. It is helpful to remember that every calendar year is filled with ups and downs (see the graph below). Currently, the S&P 500 has gone 1000 days without a 10% correction and one thing we know – the longer we go without a correction, the closer we are to the next one.
Despite the risks of a market decline (which are always present), we see no need to shift our allocations or strategies. We will continue to embrace diversification between stocks, bonds, and alternatives. We like the relative price of foreign equities, but also appreciate (and want to participate in) the upward momentum of U.S. stocks. We will continue to rebalance as needed to keep our portfolio’s risk and reward profile in line with expectations.
GDP vs. Employment (and Everything Else)
Despite the observations made above and improvements in the labor market (the Bureau of Labor Statistics issued a robust employment report on July 3rd), the economy has its challenges. In fact, The Bureau of Economic Analysis issued a revised estimate of Gross Domestic Product (GDP) for the first quarter of 2014 and the results were not good. First quarter GDP was revised downward to -2.9% from the previous estimate of -1.0%, making it the worst quarter since the recession ended.
Through many lenses this looks awful. Not only was the downward revision much larger than expected, but a contraction of this size is often a precursor to a recession. Many economists expect the decline in output associated with weather and inventory management to be recaptured in the 2nd quarter, but to some this looks like lipstick on a pig.
How can a contracting economy be reconciled with expanding employment, record corporate profits, and a stock market continuously making new highs? As is often the case with headline statistics like GDP, the top-line number can be deceiving. A closer look reveals that:
- GDP as an economic indicator has its flaws, and
- The primary driver of this large revision – healthcare spending – is just one of many long-term structural problems which will have a negative (but unavoidable) impact on future growth.
GDP – A Primer
Gross Domestic Product (GDP) is the market value of all goods and services produced within our borders in a given period. This can be calculated several ways, but the most commonly used method is the expenditure approach, which sums all that is spent on consumption, investment, government, and imports (net of exports).
There are several widely recognized problems with using GDP to measure economic activity, some of which may be magnified as our economy evolves over time. This does not negate the value of the metric but it is helpful to understand its drawbacks. A few examples:
- GPD measures price, not value. Price alone often fails to adequately capture the perpetual improvements in quality we see in many of our purchases. Example: When a car has new features (increased fuel efficiency, navigation system, rear view camera, keyless ignition) and no change in price, there is no net increase in GDP, despite the big increase in value to the consumer.
- GDP fails to capture the value of free products in our evolving digital economy. Example: Online search, social media, GPS navigation, email, and storage are all services on which we heavily rely, but which count nothing towards GDP.
- GDP does not deal well with the complexity of global manufacturing. Example: Apple’s iPhone is designed in the U.S. and assembled in China using parts made from all over the world (including here at home), but only a fraction of the sale price counts towards U.S. GDP.
The Paradox of Thrift (and Healthcare Reform)
Despite its shortcomings, GDP still provides a means to compare economic activity over time, and as the graph above displays, the rate of economic growth in the U.S. has been gradually slowing over the last several decades. Some of this may be due to flaws in measurement as explained above, but it is clear that the current recovery is far weaker than previous post-recessionary periods.
The Paradox of Thrift, a central theory of modern economics, argues that if too many people cut spending (to increase savings or reduce debt) all at once, the net effect on the economy will be negative. Since the end of the recession, this paradox has been playing out writ large as consumers, companies, banks, and (to some extent) governments have cut spending to build reserves and deleverage.
Changes in our healthcare system are having similar effects. One can argue about the pros and cons of Obamacare (Affordable Care Act), but the need to reign in healthcare spending is irrefutable. (Healthcare spending peaked at an unsustainable 17.3% of GDP in 2011.) Any efforts to cut costs, eliminate unnecessary procedures, or lower excess healthcare consumption will have a negative effect on GDP. In fact, roughly 2/3 of the downward revision to GDP can be attributed to unexpected declines in revenue for hospitals (-1.3%), medical labs (-6.4%), outpatient care (-3.6%).
The economy is not the stock market and vice versa. Stocks can rise even as the economy, ever so slowly, digests the excesses of past decades.