Capital gains improve tax receipts
The below graph reflects the large growth in U.S. Federal Budget deficits post–2008 crisis. After hitting double-digit deficits, tax receipts are improving, government spending is slowing, and the annual budget deficit is declining. This is great news for investors, as the U.S. economy has emerged from the crisis zone. Unemployment has also improved—though, as noted above, the ever-important consumption data is still not at as strong as it could be. This article considers the improvement in Federal spending within the context of overall economic growth and the implications for U.S. equity investors.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Back on budget… Well, almost
Consumer spending in the U.S. was supported by rapid appreciation of housing and equity prices until 2008, with Home Equity Lines of Credit and marketable securities–related credit fueling both domestic demand as well as imports. Since 2008, equity prices have recovered, and bond prices have risen, though housing prices have lagged—still 20% below peak levels—while the S&P 500 is 20% above pre-crisis peak. Interest rates remain low, supporting purchases of capital goods, such as autos. Large government deficits, including unemployment insurance, have filled in this consumption gap.
Domestic net worth record $80 trillion
Much of the current “recovery” of the U.S. economy may be concentrated too heavily in reflated asset prices, which may allow the wealthier Americans to resume spending patterns. However, for the large majority of U.S. consumers, a variety of negative factors persists, and may not be corrected in the near term. This issue is covered more extensively in the related article The Fed favors the wealthy: Good for investors, not middle America.
Middle America still feels the pain
Indeed, there are a variety of factors out there that suggest that consumer spending in the USA is coming under increased pressure, and appears to be losing momentum. In the near term, tightening credit conditions, a cooling housing recovery, and government deficits could constrain U.S. consumerism. Looking forward, it’s hard to be optimistic about the U.S. consumer sustaining the current level of pre-crisis consumption, and the above graphs suggest the middle America consumer is feeling the pinch of deflation in their home value and the lack of real wage growth. The monetary steroids are wearing off, and the economic pain of too much consumption relative to too little re-investment could be felt with increased intensity.
Although this bodes poorly for equity markets, recent economic growth data and equity-related valuations, including associated tax receipts, have supported both corporate profits and government finances. While great for investors, the fundamentally important middle America consumer data hasn’t been as robust.
To see how small-cap growth shares have fared in comparison to small-cap value shares since the financial crisis, please see the next article in this series.
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).