The U.S. Economy
The advance estimate of first quarter 2016 real GDP came in at a 0.5% seasonally adjusted annual rate. A decline in business spending was the primary drag on the economy, as nonresidential fixed investment detracted from the overall growth rate. Net exports detracted from the growth rate as well. In contrast, personal consumption expenditures were a strong contributor to growth, almost all of which came from the services category. Housing continued to be a solid contributor to GDP growth, as residential fixed investment rose 14.8% in the first quarter, the fastest pace since the end of 2012.
Despite the weak GDP estimate for the first quarter, the economy continues to produce solid job numbers. Nonfarm payrolls have grown by an average of 234,000 per month for the past year. In March, the unemployment rate ticked up to 5.0% from 4.9% the previous month, but the overall size of the labor force increased, which could suggest more people are optimistic about being able to find a job. The participation rate reached a two-year high of 63.0% in March.
The U.S. Dollar Index (a geometrically-averaged calculation of six currencies weighted against the dollar) declined during April, continuing its downward move since the start of 2016 (particularly since the beginning of March). The Federal Reserve did not raise the federal funds rate at its April meeting, and markets read its statement following the meeting as suggesting the Fed is in no hurry to raise rates. Expectations for continued low interest rates weighed on the dollar's performance. Also, the Bank of Japan's announcement at the end of the month that it would not provide additional stimulus measures defied market expectations and caused the yen to rise sharply against the dollar.
Inflation eased slightly in March, as the headline Consumer Price Index (CPI) was 0.9% year over year, down from 1.0% the previous month. Core CPI - which excludes food and energy - rose 0.1% month over month, down from 0.3% readings the previous two months. The year-over-year core CPI figure was 2.2%, down from 2.3% in February. A decline in clothing prices, which fell 1.1% month over month, was the principal factor behind the lower March readings. In contrast, gasoline prices increased by 2.2% month over month.
The Personal Consumption Expenditures (PCE) price index, which is the Fed's preferred inflation metric, increased 0.8% year over year in March. The core PCE price index fell to 1.6% year over year from 1.7% in February. The Fed's stated inflation target is a 2.0% annual change in the PCE price index. The Fed continues to debate the degree to which earlier declines in energy prices, which have been pushing down year-over-year headline inflation, are transitory as it weighs further adjustments to policy interest rates.
Global Economy
Consistent with our expectations, the Chinese government for the time being appears to have used its policy tools to avoid the "hard landing" that many investors feared in 2015. Specifically, government stimulus implemented in the second half of last year - targeted at housing markets and other areas of property - seems to be filtering through to the real economy. Nevertheless, real GDP growth as reported by the government continued to decelerate in the first quarter.
The market reacted positively to the increase in Chinese property investment, as reflected in the recent rebound in commodity prices and rally in emerging markets that depend on external demand for commodities. The question becomes whether these are durable trends.
Despite the upbeat headlines, we view the data negatively. They indicate that for now, Chinese policymakers are putting structural reforms on the back-burner, choosing instead to revert to the country's old growth model (state-directed, unproductive, debt-driven investment) in the short term. One particularly worrisome data point was the widening divergence between private sector investment and investment in state-owned enterprises (SOEs). Policymakers have clearly prioritized stabilizing economic growth over pursuing more market-oriented reforms. By continuing to support growth with inefficient investment in SOEs and rising debt, China appears to be perpetuating problems that will have to be dealt with later.
The campaign concerning the United Kingdom's potential exit from the European Union (known as "Brexit") kicked into gear during April, with the "remain" camp publishing projections about the damage an exit could do to the British economy. Treasury chief George Osborne cited a government analysis that concluded exiting the EU would leave the UK economy approximately 6% smaller in 2030 than if Britain remained in the union. Osborne also personalized the potential effect by stating that would be equivalent to a loss of £4,300 in annual income for every British household.
The Organisation for Economic Co-operation and Development (OECD) published its own estimates for the effects of "Brexit," which also showed a meaningful decline in real GDP even under its most optimistic scenario. To the dismay of many UK politicians, U.S. President Barack Obama got in on the action as well, writing a pro-EU op-ed published during his trip to the U.K. that extolled the importance of the EU to both Britain's place in the world and its relationship with the U.S.
We view Osborne's announcement as largely a scare tactic, and maintain our view that a Brexit is unlikely. Nevertheless, we do believe that as each side intensifies its campaign leading up to the vote on June 23, we could see increased volatility in the British pound and further pressure on the UK equity market.
In Brazil, lawmakers in the country's lower house of parliament voted to impeach President Dilma Rousseff. The debate now moves to the Senate, where a vote on impeachment is expected to happen sometime in May. There remains no clear answer as to who might succeed Rousseff, and we continue to watch carefully how events transpire given that the situation remains very fluid.
Our Perspective
Global equity markets generated modest positive absolute returns during April on both a local-currency and U.S.-dollar basis. U.S. equity markets also delivered moderate positive absolute returns. Valuations in the broad U.S. stock market remain somewhat elevated, but we continue to see little evidence of excesses in the market or economy that would need to be unwound. In this environment, discernment and flexibility are critical.
Given the slow global growth environment, in portfolios geared toward investors that need capital growth, we are targeting investments in fundamentally strong businesses that are not heavily reliant upon macroeconomic growth to drive sales and earnings. More specifically, we see value in businesses that we believe have control of their destiny and are taking share in large established markets or are creating new markets on their own. The goal is to identify companies trading at attractive valuations relative to their growth potential.
For fixed income investors and investors with a shorter time horizon or current income needs, we continue to focus on opportunities we are seeing in corporate bonds, investment-grade securities in particular. The corporate sector remains relatively cheap from a valuation perspective. Regarding government debt, a sizable portion of our portfolios' allocation to U.S. Treasuries is to Treasury Inflation-Protected Securities (TIPS), as we think the market has not been adequately compensating investors for inflation potential in nominal Treasuries given a tighter U.S. labor market and the underlying trend in core inflation.
We continue to believe that interest rates do not adequately compensate investors to take on additional duration risk, and therefore our portfolios maintain a modest duration relative to the benchmark. We would look to increase duration through the purchase of longer-maturity U.S. Treasuries or Agencies if interest rates were to increase to more attractive levels. In our view, short term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows and pay an attractive dividend could be compelling options for these types of investors in the current environment.
Sources: Bureau of Economic Analysis, National Bureau of Statistics of China, and the Organisation for Economic Co-operation and Development. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).
