Stuck in the Mush A Canadian economist scans the horizon for compelling asset classes -- and finds few
By SANDRA WARD
AN INTERVIEW WITH MARTIN BARNES -- What didn't bother the esteemed economist at Canadian research firm BCA Research when we talked last year is now cause for concern. Barnes, also managing editor of the insightful Bank Credit Analyst, which forecasts investment and business trends, sees a world where consumers need to tighten their belts a notch or two, while the corporate sector could do us all a favor and loosen theirs a bit. In the short run, all is copacetic. It's the long run that could prove more calamitous. We'll let him fill you in on the details.
Barron's: What's your outlook for the economy? Barnes: The economy might look OK now because short rates are incredibly low, but in the long term, one of the real stories is going to be the huge challenge the Federal Reserve faces in getting rates back to normal levels. It has propped up housing, propped up the consumer, and propped up the stock market with these very low rates and encouraged a lot of risk-taking.
Q: What is normal, and do rates necessarily have to go back to normal? A: History would suggest a normal level on the Fed-funds rate is around 4% [compared with 1.5% now]. To the extent that the Fed believes the economy is basically sound, the risk is that they will push rates back to normal too fast. They will only know they moved too fast when things blow up in their face, and then they will have to back off. They are somewhat boxed in. In the perfect Goldilocks world, the economy would grow at a healthy pace and inflation would stay low and the dollar would stay stable, and they could go slow in raising rates. But the world isn't perfect.
Q: Is this inflation we're seeing apt to be long-lasting or temporary? A: If you stand back and take a structural view of the world, deflation is still a bigger threat than inflation. It is still a highly competitive world and there is still the whole Asia supply story out there. Technology is still a disinflationary force in the sense that it encourages more competition and pushes prices down. The Internet is a true force for competition and low prices.
The Fed has talked in the past about creating a firebreak against deflation by getting inflation up enough and interest rates up enough so that if there is a negative shock to the economy, there will be a cushion to protect against deflation. They haven't been able to achieve that. Even though the Fed has had a very stimulative policy for some time now, they haven't really been able to create a whole lot of inflation yet. Inflation popped up in asset prices and in the housing sector in some markets, but despite their best efforts inflation has been very slow to come back. That tells you there is a deflationary tone to the world. The Fed is going to keep pushing at it and eventually is going to get some inflation. It may take a while and it may not be until later next year, but the Fed will get there unless it completely makes a mistake by being way too aggressive and the economy is sent into a nosedive again.
Q: They are getting help from the oil sector. A: They are. But higher oil prices aren't being passed through to overall inflation. Some companies, like FedEx and other transport companies, can pass it through, but companies that use oil to produce stuff are finding it harder to do that. The core inflation rate is still very subdued. The worry I have longer-term is, what happens in the next downturn if we head into it while interest rates are still quite low?
Q: Are we heading into that next downturn? A: I don't think so. We don't fully understand what's behind this soft spot in the economy, although oil is a part of it. Withdrawal of the tax stimulus is also part of it. But there is something else going on. Businesses have been very cautious coming out of the recession. They have been through the wringer in terms of what happened to profits and all the accounting scandals, and they have stayed very, very risk averse. They were in a real severe retrenchment and it will take them a long time to come out of that. Capital spending started to pick up last year, and hiring only picked up this year. The worry is that companies are going back into the bunker again because they look out the window and they read the papers and there is nothing that makes them feel good. Oil prices are up. Geopolitical worries certainly haven't gone away. Consumers have cut back a little. All these are reasons why the corporate sector might say, "Well, let's just hold off for a while here," and that then becomes a self-fulfilling prophecy. Employment gets weak again, as it has, and sets the consumer back.
Q: You were very positive last year on the shape the consumer was in. But what about now? A: There were a lot of worries a few years ago about low savings and consumer debt levels and concerns the consumer had no life left at all. But our work showed the savings rate was actually a lot higher than the official numbers suggested. And there was no evidence that debt was a real problem. Obviously, the consumer didn't cut back and was helped out by tax cuts. But there is a limit to my optimism, and debt can't keep expanding faster than incomes forever. When you start adjusting the savings rate, it is low and it has to go up. The Fed managed to minimize the recession by cutting rates very aggressively, which kept the housing sector strong and kept the consumer spending and borrowing. There was a deep recession in the corporate sector, but a mild recession overall, because the consumer was propped up. Basically, the Fed stole growth from the future. Consumers who bought their cars yesterday aren't going to buy them today. The same goes for houses. There is a payback. We can't expect the consumer to re-accelerate here. The best you can hope for is that employment picks up again.
Q: That seems to be touch and go at this point. A: If employment picks up similarly to what we saw earlier in the year, then incomes will keep growing and the consumer can keep spending. But the consumer can't become the source of faster and faster growth. The best you can hope for is that the consumer hangs onto a growth rate of about 2½% to 3%, and the real boom comes more from the corporate sector and the trade sector.
Q: You were just at the Jackson Hole confab of central bankers. What was the buzz there? A: Generally, my sense is the Fed is sticking to the view that the economy is in decent shape. This soft patch is explained as part of the normal ups and downs of the economic cycle and oil is a part of it. I didn't get a sense of real concern.
Q: But you beg to differ? A: No. The economy is fine at the moment. But it is only fine because we still have very low interest rates. That is keeping housing firm. It is keeping the stock market firm. And it is encouraging risk-taking to a degree. The issue is, what happens when you move away from these very low short-term rates? It is going to be tough to get the timing right without undermining housing, without undermining the economy. They can do it, but it is a tough environment. Against this backdrop are a lot of longer-term issues and concerns in terms of imbalances and debt and so on. The record current account deficit and high levels of leverage don't provide a great long-term environment for markets.
Q: And thus your view that long-term returns will be modest? A: Assume that the economy does OK and keeps growing. Then you've got to expect rates are going to go up. From a long-term point of view you can't get hugely excited about bonds from this level of yields. As far as the stock market is concerned, we are now past the peak in terms of earnings growth. Earnings growth is now going to decelerate back to the underlying growth rate of the economy, about 5%. Also, it's hard to make the case that valuations are going to go up. Valuations are better than they were a couple of years ago, but the market isn't cheap. Let's be generous and say the market is fairly valued at current P/Es [price-earnings ratios]. Even if it is a little bit cheap, rising interest rates are an offset. It is hard to make the case for valuations to go up on a sustained basis. We're left with 5% earnings growth and a low dividend yield, about 1¾%, so the best we can hope for is 6¾%, and that's assuming valuations don't get compressed. That isn't a disaster, but it is roughly half of what returns have been historically. Risk premiums to me look very low across the whole market in a world that looks quite risky. Again, that is what very low short rates will do for you.
Q: This sounds dire, especially with all the baby boomers staring at retirement. A: It is dire in a world were people haven't saved enough and where expectations are too high.
Q: If bonds and stocks don't look too attractive, what asset class does? A: It is one of these periods where nothing really looks compelling. Stocks in the short term, the next three to six months, could stage a decent rally. But from a longer-term perspective, there are no real bargains. Commodities went up a lot last year, so they aren't particularly cheap. It is really hard to pinpoint a major asset class that is screaming "buy me."
Q: What about gold? A: I'm not a big gold fan. Gold would do well if we go back to a big inflationary environment, but that isn't likely. Given there is a disinflationary undertone to the economy, the gold story isn't clear. There is no God-given right that says at any moment in time there has to be some asset out there that's a bargain. That makes it really tough for investors, because being in cash with its 1% return isn't exactly rewarding.
Q: No, but given the risk profile in the world maybe cash isn't such a bad place to be. A: But stocks are still stocks, and they are going to beat cash in the next 10 years. If stocks can't beat cash in a 10-year time frame we are going to be in real trouble.
Q: Last year, you were high on emerging markets. A: We cut back earlier this year, but now we are positive on them again because they really got quite cheap relative to the developed markets.
Q: How important is the presidential election in the U.S.? A: I don't think it is a big issue. There are lots of reasons to be uncertain and you can put the election on the list. It isn't totally irrelevant. There is a general assumption, and it is probably the right one, that whoever gets elected isn't going to be making major policy decisions that will affect the economy and the markets. The fiscal situation will constrain whoever is in the White House. If Kerry wins, the hope is that he won't have control of Congress. There will be gridlock. And the market likes gridlock in the sense that no government is good government.
Q: Where do you see rates by year end? A: The market is priced for 2%. The recent jobs report was good enough that the Fed will raise rates again by another 25 basis points [0.25 percentage point] in September.
Q: At what point do foreigners decide they don't want to be propping us up? A: This is an important part of the puzzle. How come the U.S., a country with an enormous current account deficit, was able to run with these incredible low short-term interest rates without causing a currency crisis? The reason is that foreign central banks have stepped in to buy the dollars that private investors weren't prepared to buy. How long can this continue? The good news is the Asian central banks have no incentive to stop doing this, in the sense that it keeps the American economy strong, which keeps the demand for imports strong, which benefits Asia immensely. From their point of view, the situation keeps their factories running, employs their people, allows cheap goods to come to America and America pays them with an IOU. They file that away in a dusty drawer somewhere and everybody is happy.
Q: How concerned are you about the dollar? A: The dollar is still a risk factor. Down the road, the dollar has to fall -- possibly quite a lot. In a perfect world, it will fall in a nice, benign, calm way without causing great problems in the markets. But we don't live in a perfect world and currencies often move in a very volatile fashion.
Q: How does Europe play into what is happening in the U.S. and in Asia? A: It doesn't. Europe moves to a different drummer: Its growth rate has been disappointing over the years and it is probably not going to change a whole lot. There are structural reasons why it is a slow-growing economy. It is partly demographics. Its policy environment is generally tighter. It is a less dynamic region. On the margin there are some efforts at reform, particularly in Germany, but it is hard to see Europe suddenly emerging as a great new source of global growth. Certainly the world economy would be a lot healthier and better off if Europe were pulling its weight. But the odds of Europe really emerging as a big source of global demand aren't great. The worry a few years ago was that the world was far too dependent on U.S. demand. That's improved to some degree because Japan has at least improved in the last year. There's just a question mark about whether this is a sustainable improvement in Japan or whether it is temporary. Then there is China. It is probably more correct to think about the world as bipolar, as the U.S. and China. It is no longer just the United States that the world depends on. China is a big, positive force for global growth. That isn't going to change. It will have its ups and downs, but I'm not worried about an imminent hard landing in China. China is still early in its development curve. And the fact they don't have inflation with this rapid growth tells you productivity growth there is dramatic.
Q: You're more concerned now about the consumer than you were a year ago. What about housing? A: I didn't think housing was in a bubble, and clearly housing didn't blow up since we last talked. But we are a year on, and prices have gone up more, and there is new data out for the second quarter that paints a starker picture. House prices in California, you would have to say, have reached bubble proportions. In the year ending June 30, house prices in San Bernardino are up 25%; Fresno, 23%; Orange County, 21.6%; Los Angeles-Long Beach, 21.5%; San Diego, 20%. That's straight price appreciation in the past year. Those are big, big numbers by any measure. That looks pretty bubbly. Also, parts of the Northeast appear to be in a bubble. Prices in the D.C. area are up 16%. Maryland is up 15.4%. Maine is up 12%. Then you look in the interior, and Texas house prices were up less than 3%. The data comes from the Office of Federal Housing Enterprise Oversight, or Ofheo, and it's a quarterly price index based on repeat sales. The year-over-year increase across the country is the highest since 1979.
Q: So if price appreciation slows, what's the concern? A: It isn't a disaster. It would have been a disaster if housing had a major downturn when employment was still weak and the stock market was still weak. As we go forward and the economy does OK, and the Fed raises rates, and mortgage rates go up and housing turns down, that's not great but it's less dangerous because at least it's occurring in an environment in which the rest of the economy is strong.
Q: All in all, how would you sum up the state of the economy? A: If consumers are cutting back, and the corporate sector isn't willing to accelerate spending, then we're stuck with a mushy economy.
Q: That's what we have to look forward to? Mush? A: If oil prices come down, and the Fed is really slow in raising rates, and the global economy hangs in there, we could have a decent economy next year. We aren't looking at a recession. We've never had a recession in the past without monetary policy being restrictive. There obviously is a first time for everything, but it has never happened before, so for the economy to slide into recession would be extraordinary at this point. You would have to shock it with something pretty bad. I don't see that. I'm not worried about that. The corporate sector is in decent shape. The consumer sector is in decent shape. The consumer balance sheets are good. This rise in house prices has done wonders for consumer balance sheets. The stock market up significantly from its lows has done wonders for consumer balance sheets and so consumers are not in bad shape financially. But the savings rate is low. And we need a healthy job market. That's critical. The key to the consumer is the job market.
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