From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Rick Rieder, BlackRock's Chief Investment Officer of Fixed Income, Fundamental Portfolios, discusses the recent weak economic data in the United States, the need for greater investment by companies and how inflation is proving to be deflationary in the current U.S. environment. If you are interested in Morningstar featuring your content, please provide your details and/or submit your article here.
Economic Review and Outlook
Economic data has disappointed over the past month, with headwinds such as energy prices, global crosscurrents and the conclusion of the Federal Reserve’s bond buying programme dubbed QE2 seemingly overtaking the recovery. We believe the recovery continues at a modest though uneven rate, and don’t believe the economy will enter into another recession. However, the recent soft patch of economic data has been broad based, with below-expectations labour market news including an uptick in unemployment to 9.1%, plunges in manufacturing surveys and fresh declines in the Case-Shiller house price index. The jobs shortfall has been particularly disappointing in the small business segment where the vast majority of new jobs are created, and any acceleration of job creation would need to build on small business growth.
A key headwind for the economy and consumption in particular has been rising energy prices. The core consumer price index (CPI) measure, a key indicator for the Federal Reserve of the transmission of inflation into goods and services that excludes volatile energy and food, accelerated faster than headline CPI in May, up 0.3% versus 0.2%, respectively. Both measures were above consensus expectations by 0.1%. The energy price headwind to growth becomes even more apparent when looked at against wage inflation expectations, which have flatlined at effectively zero. However, with the recent decline in crude oil and gasoline prices, it is likely that this energy price impact should recede, and sentiment should rebound.
While we have discussed these themes in previous updates, for the United States to reach a self-sustaining path of GDP growth, other drivers of the economy such as capital expenditures (capex) and commercial and industrial (C&I) lending will need to improve. Indeed, capex by corporations is effectively back to the level it was in 2000 and distressingly, we’ve seen businesses spend more on information technology and software than on hiring. With hoards of cash on hand, it seems clear that the political and economic uncertainty continues to deter corporations from investing surplus cash or drawing C&I credit for investment, expansion and hiring. Which begs the question: does easy monetary policy in the United States, with the consequential required tightening of policy in the rest of the world (which negatively impacts multinational corporations), help or hurt this needed corporate investment?
Federal Reserve Outlook
Following the Federal Open Market Committee meetings on June 21 and 22, the committee reiterated that the central bank would complete the QE2 bond buying programme at the end of June as scheduled, and keep rates exceptionally low for an extended period. Importantly, the committee acknowledged that the economy continued to grow at a moderate pace, though below expectations, at the same time indicating that neither a new stimulus programme nor a near-term tightening move should be expected. With the blunt tools the Fed holds to encourage growth and employment less effective and counterproductive in this modestly inflationary environment, we believe the central bank will withhold action for some time while maintaining its balance sheet and reinvesting proceeds.
Market Outlook
For many months we have discussed the numerous challenges of continuing structural and cyclical impediments to economic growth including unemployment, deleveraging of the US consumer, housing market distress and burgeoning inflation. But it is the growth-inflation policy tension which has become the flashpoint recently, with much noise about whether the Fed would implement another round of stimulative quantitative easing or instead begin a tightening move to stanch the real rise in prices. As we have said previously, we believe the hurdle to a “QE3” is exceptionally high, while at the same time an early tightening of policy by the Fed is extremely unlikely.
However, while energy price inflation is indeed being transmitted to the consumer, as evidenced in May core CPI, this dynamic ultimately is deflationary (see chart), as seen in the dramatic falloff in recent consumer and business sentiment surveys. The impact of higher energy prices on the economy is tremendous and compresses economic conditions for corporations and consumers in numerous ways. Overall, it reduces disposable income and therefore potential consumption, while at the same time compressing corporate margins, dulling corporate confidence and hampering the potential for wage growth. Within this current environment of modest GDP growth, and modest wage and wealth changes, this commodity inflation, an aftershock to the economy from the historic liquidity from monetary and fiscal policy, is crowding out other spending and consumption.
So while the market has begun to price in the longer term economic impact created by energy price inflation, it is also trying to make sense of the increasing range of risks to growth. Those risks include reduced liquidity from the conclusion of QE2, European peripheral country crises, U.S. debt ceiling political wrangling, emerging markets policy tightening and hostilities in the Middle East/North Africa.
In light of these risks, and with volatility and illiquidity having a larger impact on risk assets, investors should continue to evaluate trading up in quality within sectors to protect against volatility events. At the same time, however, the recent flight-to-quality trade into Treasuries has exposed some fundamentally strong assets to be potential buying opportunities, some even at distressed levels. Indeed, while caution is required, selected commercial mortgage backed securities, agency mortgage backed securities and high yield corporates are attractive to maintain portfolio liquidity while receiving yield.
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