Thu, 25 Jun 2015
The U.S. economy is bouncing back from first-quarter headwinds, but in the long run it can't grow more than about 1.5% per year, says David Kelly, chief global strategist for J.P. Morgan Funds.
Tim Strauts: I'm Tim Strauts, coming to you from the Morningstar Investment Conference. With me today is Dr. David Kelly, chief global strategist for J.P. Morgan Funds.
Thank you for being here.
Dr. David Kelly: Glad to be here.
Strauts: In your talk, you discussed the economy and the markets. Where are we with the economy right now?
Dr. Kelly: I think the economy is actually bouncing back quite nicely. It was in a lull in the first quarter. We saw negative economic growth, but we think we'll do about 3% growth in the second quarter. So, we're looking at about 3% growth in the second quarter, about 2.5% growth for the rest of the year and maybe next year. So, overall, the economy is bouncing back quite strongly, and we feel pretty comfortable about overall demand growth in the U.S. economy.
Strauts: What about oil? Oil has really fallen over the last year. What kind of effect is that having on the economy?
Dr. Kelly: Oil always overshoots. It was too high when it was $110 a barrel; it was too low back in January when it was down in the $40s. It's come up since then.
A lot of people talk about another dip in oil prices. On average, we think oil prices, though, will move up, because when you've got prices down 50% from where they were a year ago, that is affecting consumption, and it is affecting production. We are seeing a lot less investment spending domestically in oil production. I think that's probably going on around the world. So, I think that's going to limit the growth in supply.
And we are also seeing a bit more wastefulness. A lot of people are buying light trucks and SUVs and driving more. The traffic jams around the country are kind of appalling right now, and that's also going on around the world.
So, as people adjust to these lower oil prices, we are going to see an increase in consumption, we are going to see a reduction in production, and we think that will cause prices to gradually move up over the next two years.
Strauts: The U.S. dollar has also risen quite dramatically in the last year. What kind of effect is that having on the economy?
Dr. Kelly: It is not good. A high dollar really hurts us in terms of exports and export jobs, and I hate to lose export jobs. We're already running a big trade deficit. This is going to … hurt the trade deficit further. So, it is slowing the economy.
The one thing I would say, though, is that this economy doesn't have much capacity to grow. Labor supply is growing very slowly. Productivity is growing very slowly. I think in the long run, the U.S. economy can't really grow more than about 1.5% per year.
If that's the case, then even though a high dollar is dragging on the economy, if it only drags on the economy enough to make the economy grow by 2.5% rather than, say, 3%, if that's what it does, 2.5% is more growth than we can actually handle in the long run anyway.
So it's a drag on the economy. I don't like to see the dollar being too high. But honestly, if it wasn't for a high dollar, I think we'd just overheat sooner.
Strauts: Let's move on to the Federal Reserve. Everyone is talking about a possible rate hike. What's your view on rates and what that will do for stocks and bonds?
Dr. Kelly: The Federal Reserve has actually been quite clear about this, and I think sometimes financial markets seem to be pricing in something different. But what the Federal Reserve has said is that, when they see further labor market tightening and when they are confident that inflation will move gradually back toward 2%, then they will begin to hike rates.
I think a pickup in growth to about 3% in the second quarter will cause further labor market tightening, and I do think that if the dollar stabilizes or comes down, and if oil prices gradually move up, if those things happen, then I think you will see inflation gradually move back toward 2%.
So, I think the conditions will be in place. They could move on July 30. I don't think they will. We will get a lot of data, actually, on that day. It's going to be quite hard for them to interpret it all. But I think by the middle of September, they will raise rates, and I think they will raise rates once then, skip a meeting, then raise rates again in their December meeting before the end of the year.
I think two rate hikes before the end of this year, and then continuing at a slow pattern of rate hikes in 2016.
Strauts: So, Sept.1 is the first rate hike you are thinking, because they will need some time to digest the data coming out in July?
Dr. Kelly: Yes, it's on July 30 the Federal Reserve is meeting, and we get revisions to GDP, we get an advance number for the second quarter, we get revisions going back a number of years. They are going to want to look at that carefully. They can't do that all in an afternoon.
I think they are too slow. I think they should have started raising rates already. But given the character of the Federal Reserve, given the fact that many people now expect a September rate hike, I think more and more members of the Federal Reserve are comfortable with that as a liftoff point.
Strauts: I thought it was interesting you mentioned that the Fed publishes projections of future Fed funds rates, and you think actually they are being too pessimistic. They are going to actually have to raise quicker. I haven't heard that from many other people.
Dr. Kelly: If you look at their forecasts, what they say is the economy will grow by about 2.5% in 2016-2017, but the unemployment rate will be flat at about 5%. I don't think that makes sense, because what we know about labor supply suggests if you get that kind of growth, you're not going to be able to find the workers. It's going to actually push the unemployment rate down. So, I think the unemployment rate will be closer to 4% by the end of next year, and if that's the case, I think you will also see more wage growth. As wages go up, as asset bubbles build, as the economy really is running out of capacity and labor markets are tightening, I think the Federal Reserve is going to have to accelerate the process of rate hikes.
Strauts: One thing you mentioned is that one of the consequences of quantitative easing is the formation of bubbles. What bubbles do you see out there, and do investors need to be worried about them?
Dr. Kelly: I think there is something of a bond market bubble. We see, still, interest rates that are too low across the board in long-term corporate bonds, government bonds, municipal bonds. I do think that those rates will rise as the Fed tightens. I will say, though, for people who are invested in bonds and bond funds, first of all, you need to have some exposure to the bond market because if something goes wrong, that's when bonds will protect you.
And also, a bear market in bonds is not the same thing as a bear market in stocks. The last two bear markets in stocks, we were down about 50%. A bear market in bonds is a loss of somewhere between 5% and 10%. It's a difference between a grizzly bear and a koala bear; it's a smaller bear.
So, I think there is a risk there, but there are also other places. There are real estate bubbles in London and New York and San Francisco. I think there is a bubble in terms of the amount of cash people hold. And I also think these bubbles could get worse. The longer the Federal Reserve keeps rates very low, the more it distorts financial markets, the greater the danger of bubbles forming. So, it's very important for the Federal Reserve not to allow this to continue too much longer.
Strauts: You also mentioned the China bubble, the China stock market. How does that affect U.S. investors? Does it affect people in emerging-markets funds?
Dr. Kelly: Not too much. I don't want to overemphasize the Chinese stock market bubble. I think there is a bubble on the Shenzhen Exchange, where we see P/E ratios of 40 times, and we certainly see a herd-like mentality among Chinese investors as they are trying to open retail accounts and want to get out of real estate, get into stocks. And so it's a perfect area where you would expect a bubble to form.
I don't think that really hurts the global economy that much. The global economy's exposure to the Chinese stock market is tiny. But it's just more evidence of the problems that monetary authorities cause--and indeed, governments in general, fiscal policy as well as monetary policy. When you try to shape the global economy, you have a tendency to build bubbles.
Strauts: Moving on to how investors should allocate their assets. What areas should they underweight? Where should they overweight?
Dr. Kelly: First of all, you should start with a diversified portfolio that is appropriate for where you are in life, and I think people need a financial adviser, and they need to discuss with that financial adviser what that appropriate portfolio is.
Once you've got a chip on every appropriate square, though, I think areas that I would underweight, I would be underweight fixed income in general. I would be particularly underweight Treasuries. I would try and keep duration relatively short. I would be overweight equities to the extent that I'm underweight fixed income. Particularly within equity markets, I like European equities. I think Europe is doing a lot better, apart from the Greek headlines, and I think earnings will grow a lot in Europe.
Also, I like emerging markets for the long run. The whole developed world is running out of good skilled workers, and the ability to push up productivity, and in emerging markets, we've still got this trend of urbanization. We've got huge productivity gains ahead of us. We've got plenty of labor supply. I know emerging markets are not very fashionable right now, but for long-term investors, I think it's important to have a position there.
Strauts: Finally, what is your opinion on hedged versus unhedged international exposure? We've seen a lot of money flow into these hedged international funds. What's your view?
Dr. Kelly: Well, the difference is a little bit between fixed income and equities. In fixed income people really want stability of returns, and because of that, if you don't hedge your fixed-income portfolio, then anything international is really going to be all about the currency. Maybe you want to invest in fixed income or maybe you want to invest in currencies, but if you want to invest in fixed income, you should probably hedge.
But within the equity markets, I don't think people should buy equities unless they intend to hold it for five years or more. And if you're going to do that, then you have to think about where these exchange rates are going to go in the long run. I know the dollar is high right now, but we're running a big trade deficit. I think the U.S. economy will slow down within the next two years as we run into capacity constraints. If that's the case, 1.12 on the euro makes the dollar too high. And I think that, most likely, foreign currencies will go up relative to the U.S. dollar.
And that says, if you're going to invest in European stocks, go in unhedged, because not only will you get the benefit of the European stocks going up, but you are also going to get a kicker from the value of the euro going up. So, for long-term equity investments around the world, I would rather just go in unhedged and take advantage of rising foreign currencies, as eventually international economies outperform the U.S. economy.
Strauts: Thank you for joining me today, David.
Dr. Kelly: My pleasure.
Strauts: For Morningstar, I'm Tim Strauts.