Sorting Through Today’s Worries, Opportunities

There’s a tightening in the economy, but few people see it. That’s because this cycle differs from the past. In the old days, tighter policy occurred when the Fed raised interest rates several times and Congress raised taxes. Now, there are other forces tightening the economy.

Most people look at market, or nominal, interest rates and see that they generally are flat or a little lower this year. They don’t see a tightening.

That’s misleading. Real interest rates—which are nominal interest rates minus inflation—are what matter. As we’ve observed in recent visits, there’s a deflationary trend across the globe, and deflation is more of a risk than inflation. When nominal interest rates already are near zero, they can’t decline any more. But when inflation de-clines and nominal interest rates stay the same or decline less than inflation, then real interest rates have increased.

Historically, real interest rates have been fairly steady. Nominal interest rates often told us what real interest rates were doing. That’s not the case today. In this zero interest rate, deflationary environment, real interest rates are rising even when nominal rates are flat or slightly lower.

The Fed first tightened monetary policy by phasing out quantitative easing. It tightened again with its first interest rate increase last December. Now, it is tightening by allowing real interest rates to rise. Real interest rates also are rising across the globe, and are higher in many other countries than in the U.S.

Rising real rates reduce economic growth and make other investments less attractive than cash. Risky assets suffer price declines when real interest rates rise. Investments hurt by rising real rates include stocks, commodities, high-yield bonds, and investment-grade bonds. We’ve seen declines in these assets most of the last year, though they’ve had a recovery since February 11.

Lower investment returns are another factor tightening the economy and restricting growth. They reduce household wealth, and that reduces confidence and spending. Fiscal policy also generally is tighter because of more regulations, lower spending, and some tax increases.

This doesn’t mean the U.S. is on the verge of recession, but the economy slowed in recent months, and growth should decline further in 2016.

Weak international sales and the manufacturing recession are drags on U.S. growth. Household spending has been supporting the U.S. economy. Real retail sales (nominal sales adjusted for inflation) are well above average. Lower energy and commodity prices free up cash to spend on other things. Also, the labor market continues its steady, unspectacular recovery from the financial crisis.

Real retail sales and the unemployment rate trend are the strongest leading indicators of recessions, and they still indicate continued growth. Real retail sales growth should slow as the year goes on because of all the headwinds facing the economy, but growth should stay positive.

Investors generally have been concerned about three factors in 2016. One of them is slower growth in the U.S. Fear of a recession should decline as investors realize that, despite all the obstacles, the U.S. will continue to grow at a slow rate.

The problems in China and the potential global fallout from that are another major concern.

There’s no doubt that China is exporting deflation to the rest of the world. China has too much debt and a lot of excess economic capacity. That puts downward pressure on domestic prices. China also is devaluing its currency. Because China is such a big player in the global economy, deflation in China puts downward pressure on prices and wages elsewhere, especially in other Asian nations.

It’s possible China’s deflation will infect the rest of the globe, as we’ve noted in the past. But it’s also possible that China’s bureaucrats will patch together changes that avoid more serious problems and slowly turn its economy. We could have a repeat of the European banking situation of a few years ago. It appeared there was no solution, yet investors became comfortable with changes policymakers made, and markets recovered.

The potential extended effects of commodity price collapses, especially of energy prices, also concern investors. The initial effects of lower commodity prices are positive. Prices of goods decline, and consumers have more money to spend. The secondary effects are negative. Producers scale back their operations, reducing employment and capital spending.

The next phase of the lower price cycle is when commodity businesses default on their debts. A number of the commodity and energy producers are highly leveraged, so at some point debt defaults are likely to be high.

Unlike in many past cycles, I don’t expect this phase to have broad economic effects. Banks are not the major holders of these debts. Instead, losses are likely to be spread among a diverse group of investors who aren’t leveraged or key economic players, such as mutual funds.

There’s a lot to worry about, but as we’ve seen in recent months there also are opportunities. We continue to seek balance and margins of safety and will earn safe, solid returns.