Even though the U.S economic picture is viewed as modestly improving, we’ve experienced two straight quarters of GDP under 2% and Q2 looks to follow suit. Empirically, that just doesn’t happen in expansions, but it’s what we’ve lived for almost two years now. The minutes from the June FOMC meeting continued on the thesis of improving structural conditions in the domestic growth picture for the medium to longer term as well as diminishing downside risks, but they are concerned with declining inflation, the other FOMC mandate, although they do view this as predominantly transitory right now. June CPI showed a marginal tick up, but this has been a problem for some time (see WANTED: Growth and Inflation). As accommodative as monetary policy has been, it has been successful in lowering the risk premium, but not igniting growth.

Clearly fiscal policy HAS had an impact. Not sure how that is debatable. However, the market has been extremely resilient in the face of slack growth, a 120 basis point rally in 10 year rates, declining inflation and a degrading credit situation in the Emerging Markets (EM). Who would think with that backdrop the US domestic equity markets would be up over 18% for the year while the rest of the world (sans Japan) was sucking for wind? While the MSCI Developed market index is up around 7% this year, strip out Japan (+ 22% approx. YTD) and the returns are considerably less.

The EM internals have been very disconcerting. While US equity market volatility jumped in June to the highest levels since the eve of sequester, emerging market volatility surged to levels last seen during the sovereign debt crisis of September 2011. Much of this was attributed to recent concerns on slowing growth and credit issues in China as well as significant pressure on the core BRIC economies. To be sure that credit was the concern, from the year high in the JP Morgan Emerging market credit index on May 2nd, to the low on June 24th, the index lost just over 12.5%, almost 90% of what the MSCI Emerging Market equity Index lost over the same period. The default swap index on EM CDS investment grade bonds traded at 2011 levels in June, whereas the US CDS investment grade index was nowhere near these levels. These economies have had a very challenging time with slow growth and inflation globally resulting in weak demand for commodities. Unless something changes in that equation, the relative value trade remains undoubtedly in favor of U.S domestic equities over international.

In the face of the current growth environment, how are the markets going to continue to provide returns for investors commensurate with the risk? The IMF just lowered their forecast for global AND U.S. growth for this year. The Chinese government also said last week “growth as low as 6.5% may be tolerable in the future”. Investors have become increasingly anticipatory of a revitalization and return to trend growth and employment in Q4 and 2015, respectively. The Fed propagated this in the June minutes by communicating their view that structurally speaking, growth is improving, labor markets are solidifying and weak inflation will be transitory. Corporate balance sheets remain strong and efficient and inflation is low. The housing market has been strong, but with rates up 120 bps, mortgage aps are already dipping. The consumer has held up, and hourly earnings have started to move marginally higher. Retail sales figures for June weren’t pretty, but volatile markets tend to do that to people. Right now, in technical economic terms, we are fine. Growth at 2% can plug along, but only for so long. PIMCO coined the term “new normal” in 2009/10 and caught flack for it. Were they so wrong? It is absolutely critical the economy move up to meet the market this time. Catalysts remain elusive while the sources of drag persist. Fiscal policy has to become neutral, forget about accommodative, in order for the true economic engine, corporate America, to regain confidence. The back half of July carries some significant data points, with the usual suspects of regional/national output measures, culminating in Q2 GDP and the FOMC rate decision on 7/31. Usually I would not put stock in June/July numbers, but as starved for signs of life as we are and as focused on the Fed as we have become, it is what it is. Volatility is not out of the picture.

-Bryan Novak

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