Board of Scholars

Stick with Stocks

I’m sticking to it. About a year ago in this space I said we should “expect slow growth and low financial returns unless government spending and debt declines.”

Since this has held true it is hard to find good news in the financial markets. Nonetheless, investors need to stick with stocks as the alternatives look worse.

The only good economic news is that overall prices are rising slowly. Both consumer and producer prices are increasing at historically low rates. Even so, inflation may be reaching a level that policy makers consider too high, and they will therefore raise short-term interest rates higher this year. Such moves will hurt bond prices.

Speaking in Sacramento May 13, John Williams, President of the Federal Reserve Bank of San Francisco, said “inflation has been moving back up to our goal.” You heard that right, our monetary policy makers have a goal for inflation – they want the purchasing power of US currency to decline by about 2 percent per year.

Through April of this year the consumer price index rose at an annual rate of 1.1 percent, compared to 1.6 percent for all of 2015. The Fed’s preferred measure of inflation is called core PCE, defined as the rate of change in prices of personal consumer expenditures excluding food and energy. This inflation index rose 1.6% over the past 12 months.

Fed policy makers also have a congressional mandate to help the economy reach “full employment.” By many measures this goal has been met. The national unemployment rate, a little below 5 percent, is at the historical long-term average for the U.S.

Economists consider this rate “normal”, that is, we currently have a level of unemployment that we should expect in a dynamic economy. Despite this normal level of employment the Congressional Budget Office currently estimates that US real GDP is still about 2 percent below potential.

People are working but not producing as much as they could. Business and consumer demand must grow faster to close this gap.

To get a sense of why the economy is weak and prices are growing relatively slowly we have to consider what is holding back consumer purchases and business investment. The strong forces holding back demand have not changed – consumers have too much debt and business conditions are uncertain.

As of the end of 2015, U.S. households have $14.2 trillion in debt outstanding. This is the same level as the start of 2008, and remains 78 percent of the nation’s annual income. If we add to this the burden of government debt we can see why consumers are not willing to spend like they used to.

Consider now why business owners and managers are also not spending like they have in the past. For the first quarter of this year, gross domestic private investment grew at only 0.3 percent.

Business conditions reflect uncertainty at home and abroad. Questions regarding the policy outcomes of the upcoming presidential election, ongoing fiscal challenges at the state level, and slow economic growth around the globe all lead to lower overall business demand.

With a weak economy and uncertain outlook investors face limited choices. Prices for financial assets reflect the fact that the headwinds facing consumers and businesses have not improved much even though the stock market has bounced back from its fall at the start of the year.

Investors are continuing to seek the “safe-haven” investment of U.S. government debt. At 1.7 percent, the yield on the 10-year Treasury note is half of what it was before the financial crisis. Even very long-term bonds do not pay. The 30-year Treasury bond yields only 2.5 percent, also half of what it paid in 2007.

With an overbought bond market and ample supply of commodities keeping price gain potential low investors have little choice but to look at stocks. Despite the inherent greater risk in stocks over bonds there are sectors that should continue to do well in the current economic environment.

A slow growth economy with low interest rates and stable prices favors large-capitalization stocks in the consumer staples and healthcare sectors. Conversely, the continuing weak consumer demand does not favor the consumer discretionary and industrial sectors.

Further, investors would do well to stay globally diversified as economic growth is likely to pick up outside the U.S. first. Economists at the International Monetary Fund argue that “Emerging market and developing economies will still account for the lion’s share of world growth in 2016….”

Stick with the only investment that has the potential to overcome the Fed’s goal of destroying your purchasing power by 2 percent each year. Stick with stocks despite weak economic growth.

 

Peter R. Crabb, Ph.D.Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments. 

[i]http://www.frbsf.org/economic-research/publications/economic-letter/2016/may/economic-outlook-springtime-is-on-my-mind-sacramento-speech/
[ii]https://research.stlouisfed.org/fred2/series/CPIAUCSL
[iii]https://research.stlouisfed.org/fred2/series/UNRATE
[iv]https://research.stlouisfed.org/fred2/graph/?g=3fEi
[v]https://www.federalreserve.gov/releases/z1/current/
[vi]https://research.stlouisfed.org/fred2/series/GPDI
[vii]http://www.imf.org/external/pubs/ft/weo/2016/01/pdf/c1.pdf

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.