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The main reason that we believe short-term interest rates will stay low is that the Ben Bernanke, the head of the U.S. Federal Reserve, has consistently repeated his view that the ‘Fed’ will leave interest rates at such low levels right through 2014. While this outlook on interest rates doesn’t necessarily correspond with our view of stronger economic growth, you have to dig a bit deeper into the history of the current Fed Chairman to understand his rationale. He is a keen student of the period following the crash of the U.S. stock market in 1929 and the subsequent depression in the 1930s. History shows that the biggest mistake made in that decade was that the central banks began tightening policy (i.e. raising interest rates and making credit less available) far too quickly after the economy began to recover. Since inflation was not a problem they could have left interest rates lower for a longer period of time. But they opted to tighten policy and ended up driving the economy back into a second, even more severe, recession and a subsequent further sharp decline in stock prices through the rest of the 1930s. Fast forward eighty years and it is clear that the Fed does not want to make that same mistake again. Since inflation remains completely subdued, the Fed will continue to opt for sticking with low interest rates for a longer period of time, both to make sure that the recovery is sustainable as well as preventing debt servicing costs from sky-rocketing. Imagine the impact of a sharp increase in interest rates when debt levels are at record highs!
While we have also upgraded the Economic Growth indicator back up to 1, mostly on some stabilization in Europe as well as an improvement in the U.S., the key risk for the global economy continues to be the ability of China to slow their growth rate down to the 7.5% range without overshooting that target on the downside – i.e. the ‘much-anticipated soft landing’ scenario. Recent data has definitely been softer as the economy is still feeling the impact of the increase in interest rates 18 months ago that was needed to cool off inflationary pressures that were rising in China, particularly in the housing market.
But China’s inflation rate has now fallen from a peak of over 6.5% in July of 2011 to 3.2% in February, 2012. Inflation was one of the major concerns for the Chinese leadership last year and the key reason why interest rates and bank reserve requirements were raised. Now that inflation is off the radar screen as a top concern, investors can focus on growth again. This may now be achieved by additional stimulus or by easier monetary policies. In the end, the most important thing in China is to keep the massive working population employed and try to create a more consumer, oriented economy to support the expansion of the manufacturing base. Investors are worried that the government’s recent move to reduce the long-term planned growth rate from 8.0% to 7.5% means that the days of great Chinese growth were coming to an end and that this would also mean the end of the tremendous move in commodities we have seen over the past 12 years. This could not be further from the truth in our view! First of all, China exceeded the 8% target for most of the time it was in place and we expect that trend to continue; periods of slowdown will drop it to that range or even briefly below it, but we expect the average growth rate to comfortably exceed the 7.5% target. Also, the base of the Chinese economy is much larger than it was when the prior plan was put together, meaning that a 7.5% growth rate on the current economy adds more to the global growth picture than the 8.0% growth rate on the prior plan. For the commodities market this means that the absolute tonnage of copper, iron ore, metallurgical coal, oil and all the other basic resources that they import will continue to be substantial and not below prior levels. Finally, China is but one of a large group of emerging market economies which are making the same transition from rural, agricultural-based systems to urban, industrial-based systems. These trends are not going to reverse and will sustain global growth for many years to come.
Our profits indicator remains positive, at +1. Corporate profit growth has slowed down in the past year from a 20% annual rate about 10% in the past quarter, which is why we downgraded from +2 to +1 late last year. But profit margins also remain near all-time highs as companies keep a tight lid on expenses and benefit from record cash levels. More importantly, analysts have been too negative in their assessments of future growth and are now having to upgrade either their earnings outlooks or price targets for stocks in their coverage universe. The chart below from Merrill Lynch shows their Earnings Revision Ratio(ERR). While outlooks were rolled back over the past two years due to fears about a double-dip recession, we have seen a recent upturn in earnings upgrades. Such turns have generally coincided with the rallies in stock prices. Given that valuations of stocks remain reasonable, an improving earnings outlook could sustain an upward move in stock prices.
