Not only is the future uncertain, so is the past and present. Two recent events provide examples. "Breaking: Two Explosions in the White House and Barack Obama is injured" was tweeted from the Associated Press (AP) account. The message, the result of the AP's Twitter account being hacked, caused a brief 150-point plunge in the Dow Jones Industrial Average, wiping $200 billion from the value of the U.S. stock market in a few minutes. In actual news, researchers from the University of Massachusetts Amherst cast doubt on a widely read study published in 2010 by Carmen Reinhart and Kenneth Rogoff of Harvard University. In "Growth in a Time of Debt," Reinhart and Rogoff examined data since 1800 and found that countries tended to grow more slowly in real (inflation-adjusted) terms when their ratios of national debt to gross domestic product (GDP) exceeded 90%. They estimated that debt above that threshold curbed the annualized rate of growth by 1.5 percentage points. The new UMass study asserts that a spreadsheet error led Reinhart and Rogoff to overstate debt's impact on growth; proper calculations, the UMass authors say, show that growth in periods of high debt actually lagged growth in periods of low debt by 1 percentage point.
We cited Reinhart and Rogoff's in our Capital Markets Forecast 2013–2019, and we have been asked if the error's discovery has changed any of our opinions. In short: No. In our forecast, we identify high debt-to-GDP ratios in the United States and elsewhere as being a headwind to future growth. An examination of the underlying data reveals variations that are lost in averages; we do not consider either averages or medians to be precise. Both studies found that high debt levels pose significant drags on growth. They differed in their conclusion about the size of the drag. We remain comfortable with our conclusion that a high debt-to-GDP ratio is a headwind to future economic growth.
Changing economic data is the norm
In a larger context, many economic datasets are revised, one or more times. Consider, for example, that the U.S. Commerce Department makes three estimates of U.S. GDP every quarter. It sometimes revises the "final" estimate years later. The lesson is that investors must recognize not only what they don't know but must consider that some of what they think they know is flawed. At Wilmington Trust, we construct and manage our investment strategies to allow for errors. For the last couple of years, we've forecasted slow U.S. economic growth. We have positioned portfolios accordingly. A slow-growing economy implies the absence of a recession, only slight inflationary pressures, and generally rising corporate earnings. In such an environment, combined with artificially low interest rates, we've held on to equities, favored slightly lower-rated bonds for their relatively high yields, and underweighted inflation-hedging assets, including commodity- and real estate-related securities and inflation-linked bonds.
As information surfaces, we reconsider our views and question whether we should revise our investment policies. Some news will suggest growth and/or inflation higher or lower than our forecast. And occasionally, the news will appear to validate our outlook. Such was the case this past week when the Commerce Department reported U.S. GDP in the first quarter expanded at an annualized rate of 2.5%, disappointing consensus expectations of 3.0%. This brings economic growth to 1.8%—unless revised—for the last four quarters. The University of Michigan Confidence survey for April came in at 76.4, down from March's 78.6 but above expectations.
Corporate profit outlook dims
With 271 companies of the S&P 500 Index reporting their first-quarter results thus far, 73% have exceeded profit expectations but 56% have missed their revenue targets. The outlook also continues to be negative, as 48 of the 59 companies that offer guidance have lowered their projections.
Don't fight the Federal Reserve, or the Bank of Japan
The Nikkei is to Japan what the S&P 500 is to the United States. Between the financial crisis and mid-November, the Nikkei underperformed the S&P 500 Index, MSCI EAFE (Europe, Australia, and the Far East) Index of developed international markets, and MSCI Emerging Markets Index. Since mid-November, the Nikkei has surged 60% and the yen has fallen 20%. Japan's performance is attributed to the election of Shinzo Abe of the Liberal Democratic Party, which led to the Bank of Japan's change in monetary policy to pursue quantitative easing and target a 2% inflation rate. The adage "don't fight the Fed"—or its Japanese equivalent—is supported once again. Japan's gain is not without consequences. The fall of the yen makes Japanese exports more competitive, particularly relative to emerging Asian exporters. It is deflationary for U.S. consumers, as it lessens the cost of U.S. imports.
Weak economic growth, the continued containment of inflation, and slow employment growth allow the Fed to maintain its loose monetary policy. In the whole, we believe easy monetary policy, continuing growth, and low inflation support the slightly aggressive structure of our model asset allocation strategies.
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