July 2015

Economic, Not Market, Growth

The Dichotomy

The second quarter of 2015 posed a dichotomy, with the economy growing and the stock and bond markets barely moving. There appear to be a number of reasons for this, some good for the long-term, others less so. Writing this newsletter in the latter part of July has allowed me to reflect on more of the information that is coming to light on the quarter just past.

The Markets

The second quarter began with the S&P 500 at 2067.9. At the end of the quarter the S&P 500 stood at 2063.1. Thus we see the stock market statistically unchanged for the quarter.  Let’s take a different approach to the market and see how it has done since the beginning of the year. At the beginning, the S&P 500 was at 2058.9 and at the end of six months it was at 2063.1. Again, statistically, the stock market was unchanged from the beginning of the year to mid-year. The bond market, however, saw diminishing return, as interest rates went up modestly, forcing the underlying value of bonds down. Depending on how an investor was diversified, the results were generally not meaningful.

What is Going On?

The question of what is going on can be answered in a myriad of ways. A partial list of what I believe represents the fundamentals includes: Greece, China, terrorism, commodities, consumer spending, wage growth, increased employment, greatly reduced unemployment, and waiting for the Federal Reserve (Fed) to make a move with interest rates.


The impact of the debt problems of Greece is not new. Greece has been living on borrowed money for a very long time and the EU has allowed this to continue to the breaking point. Now, before going any further, it is important to note that the debt of Greece is held, almost entirely, by EU governments and not the public. The difficulty with the situation is that if Greece does not pull in its belt and get its economy in balance, chances are good that it will be forced to leave the EU and the Euro. Three other EU countries face a similar debt problem, though not as dire. Italy, Spain and Portugal are all using austerity measures to control their debt and the citizens of these countries would like to see a reduction or end to such measures. Standing firm with Greece was very important in this light. On the other hand, the value of the Euro dropped dramatically and the long-term nature of their currency is now very much in question. As the Euro value went down, so did the relative dollar value of European stocks.  


About China, I don’t have too much to say other than that the government of China controls everything. While the information on growth in China has been reported as being about 7%, I think it is more likely that the growth is less. My understanding is that China needs a 12% growth rate to keep their economy from a downturn. During this year, the Chinese government pushed people to buy stocks in Chinese companies. Most of this stock--about 80%--was bought by individuals on credit. When the stocks began to fall in June, the loans were called and the markets faced a steep drop in value. The government stepped in and halted trading in most of the stocks and reduced the interest rates on loans, helping to stave off a total collapse. What this showed the rest of the world is that the Chinese stock market is controlled by the government and isn’t independent and market driven. This could have long-term repercussions on their stock markets and has made many foreign companies rethink their growth strategy in China.


With slow growth worldwide, the demand for commodities has dropped dramatically.  For countries where a large portion of their income is derived from commodities, this has had a very negative effect on their economies. Most of these countries are third world countries that were using this income to support social welfare programs. These programs are now suffering and bringing about unrest. The price of oil has dropped from about $100 a barrel to less than $50 a barrel. The price of gold is now below $1,100 per ounce. A glut of diesel fuel has occurred, with prices reaching a point not seen in many years, as the European demand for the product has been reduced.


To me, employment is a very meaningful part of the current growth in the U.S. economy. This past week the number of people filing new jobless claims dropped to about 255,000. That is the lowest since the early 1970s. In addition, U.S. companies are adding new jobs at a rapid pace, which is good news for the economy but not so for the stock market. The growth in jobs began in earnest in the second half of 2014. My contention is that the job growth impacted productivity in a meaningful way by the time we entered 2015.

When an employee is first hired but not yet trained, their contribution to the workforce is not meaningful. This lack of productivity in the early stages means that companies are paying out salaries and benefits to people who are not yet contributing to earnings.

As the employees become trained, they begin to add to the earnings level and eventually, if all goes well, the companies see a growth in overall earnings. As we are witnessing the earnings results of the second quarter, we see many companies falling short of their earnings goals. I think we could see a change in the late third quarter and fourth quarter, as many of the new hires become more productive. Since the labor pool itself is greatly diminished, with unemployment at a low point, we will see companies chasing after workers employed by rivals and this could lead to increasing compensation. With increased compensation, we could see consumer spending rise. Greater consumer spending could result in rising prices for goods and services and the potential for inflation increasing.

The Fed

The Fed is looking at the growth in employment and the lack of workers, and suspects that wages will go up. In this environment, they feel that getting ahead of the inflation curve will be critical. I anticipate, therefore, that we will see two interest hikes by the Fed before year end. This will tend to dampen the economy and could have an impact on mortgage rates and thereby housing.


Assuming no unforeseen circumstances, I think the fourth quarter will be the beginning of sustained growth into 2016.

Ed Mallon