The U.S. Economy
The first estimate of second-quarter gross domestic product (GDP) growth came in at a seasonally-adjusted annual rate of 1.2%, which was below consensus expectations. First-quarter GDP growth was revised down as well, from 1.1% to 0.8%. Despite the lackluster overall figure, consumer spending remained strong and was by far the top contributor to growth. On the other hand, business spending continued to be a detractor, as it declined for the third consecutive quarter. The largest drag on growth came from cutbacks in inventories, which could suggest businesses are skeptical about demand prospects moving forward. However, the figure can be a volatile measurement, and therefore, has the potential to bounce back over a short period.
Speaking of bouncing back, the nonfarm payroll report released at the beginning of July showed that the economy created 287,000 jobs in June, a big reversal from the surprisingly low 38,000 figure in May (which actually was revised down to 11,000). The average increase in payrolls now stands at 172,000 per month so far in 2016.
The unemployment rate ticked up to 4.9% from 4.7% due to another bounceback - this time in labor force participation, which reversed a similar decline in that figure from the previous month. The growth of average hourly earnings increased 2.6% year over year in June (the highest reading this year), a small increase from the 2.5% rate in May. We continue to regard the sometimes conflicting economic data in the United States as an indication that the economy will remain on its slow-growth trajectory.
The data also are making it difficult to discern what the U.S. Federal Reserve might do in terms of policy interest rates during the rest of 2016. At its July meeting, which preceded the GDP release, the Fed once again took no action on rates. It was more sanguine about the U.S. economy than in June, saying near-term risks to the economic outlook had diminished, pointing in particular to improving labor market indicators such as the strong payroll figure. Regarding inflation, something else the Fed is keeping an eye on, the annual core Consumer Price Index (CPI), which excludes food and energy, ticked back up in June from 2.2% to 2.3%. Annual headline CPI was unchanged at 1.0%, although gasoline prices increased 3.3% month over month. Nevertheless, the earlier decline in energy prices continues to hold down the overall inflation reading, but we expect headline inflation to move higher over the remainder of 2016 due to base effects in the price of oil rolling off.
Global equity markets moved up in July, in part because there was an easing of concerns about the United Kingdom's (UK) possible departure from the European Union (EU) - the so-called "Brexit." The transition to a new prime minister happened much quicker than expected, which removed one element of political uncertainty. Although new Prime Minister Theresa May was a member of the "Remain" camp, she stated that she would pursue negotiations with the EU on an exit plan. Despite this public stance, there is still considerable uncertainty as to whether Brexit will actually come to pass.
The issue of restricting immigration was the single most important issue for Brexiteers, yet so far the EU appears unwilling to budge from its position that the UK cannot have full trade access to the single EU market without the free movement of people. However, there is no precedent for a country leaving the EU and asking to retain the same advantages as member states without paying into the EU budget and allowing the free movement of workers. Until the details of the new relationship between the UK and EU are actually negotiated, the economic and financial impact of Brexit will remain clouded by uncertainty.
In China, the government reported headline year-over-year GDP growth of 6.7% for the second quarter, matching the figure for the first quarter. The growth came largely on the back of debt-fueled government stimulus, which adds to existing concerns about the country's debt levels and overcapacity problems that have been plaguing global commodity markets.
It is important to note that income growth is slowing in China. Household income growth slumped to 6.5% in the first six months of 2016 from 7.6% a year earlier. This is not unexpected given the country's slowdown and the transition occurring in the economy, but it will likely have a real impact on consumer-facing companies.
While the second-quarter GDP figure kept pace with that of the previous quarter, the methods used to achieve the growth rate represent a return to business as usual in China, and we see risks growing in the economy. Debt levels are rising, and inefficient state companies are not being properly restructured.
In Japan, Prime Minister Shinzo Abe announced plans for a 28 trillion yen stimulus package. There was speculation that Abe intended the announcement to push the Bank of Japan (BOJ) to provide stimulus as well at its July meeting. The BOJ did expand its purchase of exchange-traded funds (ETFs), but the modest effort disappointed markets, as the central bank kept overall asset purchases at 80 trillion yen a year and held interest rates at -0.1%.
We are skeptical about the ability of Abe's plan to generate sustainable growth in the economy. Fiscal stimulus in the 1990s failed to stop deflation, and recent extreme monetary policy hasn't produced growth through increased bank lending.
Global equity markets generated strong positive absolute returns during July on both a local currency and U.S. dollar basis. U.S. equity markets were also up sharply, with indices hitting all-time highs. 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 those with a shorter time horizon or current income needs, we still see value in the corporate bond sector, but remain mindful that we are further along in the economic cycle, and valuations are not as compelling as they were previously. We have, in fact, trimmed some of our credit exposure recently, and could look to do so again during bouts of market strength. Regarding government debt in general, our portfolios continue to have a sizeable allocation to Treasury Inflation-Protected Securities (TIPS), and we have increased intermediate-term nominal U.S. Treasury exposure to diversify sector allocation and yield curve positioning. Our short-duration positioning has not materially changed, however. We believe a shorter duration remains in clients' best interests because investors are still not being paid to take on significantly higher levels of interest rate risk (i.e., the term premium, which is the excess yield that investors require to hold a long-term bond instead of a series of shorter-term bonds, remains negative).
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 and FactSet. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).