"Kee" Points with Jim Kee, Ph.D.

OK, I’m going to try to avoid discussing a lot of the dry numbers from last week. The bottom line is that Friday’s 195,000 payroll number and upwardly revised prior months’ numbers (May and April) combine with ISM manufacturing and non-manufacturing surveys to paint a picture of continuing economic expansion in the U.S., probably in the one to two percent range (annualized growth). That’s OK but not great. I hope the second half is stronger, and in fact I expect that to be the case. But no economist is really comfortable with U.S. growth in this range.

 

Data from China, the main driver of global growth, continues to disappoint. China’s central bank (the People’s Bank of China) has said it will loosen monetary policy in order to alleviate the credit crunch there, but so far Chinese officials have not backed off of their stated intention of pursuing lower, more consumption-driven economic growth. Slower growth in China is being felt by global commodity producers and countries like Australia that are trying to transition away from being resource-dominated economies (Financial Times).

 

Nevertheless, China’s intention to ease credit, along with announcements from both the European Central Bank and the Bank of England to pursue low interest rates for an extended period of time, have given a boost to global equity markets. Germany’s approaching parliamentary elections in September seem to have put a lot of tangible policy actions in Europe on hold, despite Angela Merkel’s accurate insistence that Germany has been pursuing banking and fiscal union as ardently as possible.

 

And continued expansion in the U.S., which could hasten a slowing of Fed asset purchases, has certainly triggered a sell-off in bonds and some bond-like assets with fixed payouts, like Real Estate Investment Trusts and Utility stocks. Ten-year U.S. government Treasury yields are up almost one percentage point (100 basis points) since May, to 2.65 percent. That’s still pretty low, which is consistent with low growth and low inflation expectations. The market seems to have very quickly eliminated the ‘term premium’ that the Fed had been targeting (suppressing, really) since the summer of 2011. The move was quick, but it makes sense if you expect Fed tapering in the fall.

 

Here’s what I think: Normalization.  At the beginning of the year, developed market equities looked cheap relative to emerging market equities, at least according to those with good enough data to measure the “risk premiums” priced into these markets and compare them to history. Safe, income-producing assets looked expensive (10-year Treasury yields at 1.7 percent). By the way, and this is a big by-the-way, none of these are/were buying or market timing signals. Markets can look cheap and stay cheap for a long time, like a decade or more in the case of Japanese stocks. That’s true whether you think markets get cheap because they are irrational, or because there’s a reason (whether you can recognize it or not). You cannot use valuation as a timing signal (i.e. when to get in or out). Trust me, I’ve been involved with just about every valuation metric/timing backtest you can think of!

 

All we are seeing is a re-pricing of assets towards more normal (pre-crisis average) relative levels. No one really has valuation tools fine enough to identify when this re-pricing will be done, i.e. to identify when asset valuation levels are commensurate with forward looking risk (though many will claim to!). But as this “asset reallocation” process moves closer towards equilibrium, investors will start focusing less on asset allocation across broad investment classes and focus more upon individual security selection.

 

Quick note on Egypt: Who would have thought that ongoing Middle East turmoil, including the forced removal of Mohamed Morsi, the country’s first elected leader (amidst crowds of hundreds of thousands), would occur with $106 oil (Brent) prices (rather than higher)? Part of this is no doubt the result of increased sources of global supply, like increased production here in the U.S. Another reason, alluded to by Amy Myers Jaffe at our STMM Energy Symposium last month, is that without the turmoil, oil would be in the $80 range. Oil futures are up a bit so we’ll see. Other key points from the Symposium: Dr. Daniel Ahn estimated that the impact of exporting liquefied natural gas (LNG) - rather than forcing it all to stay here with export bans - on prices paid by LNG users here in the U.S. would only amount to about 25 cents (per thousand cubic feet). He also estimated that the impact of non-conventional shale plays on U.S. GDP growth was between a quarter and a half a percentage point. That’s nothing to scoff at in a one to two percent growth economy!