Why Growth Might be Ready to Increase

We could be set for another growth spurt in the economy. The surge in the investment markets starting on Feb. 11 anticipated that growth. The Federal Reserve, as usual, has been behind the curve and events. But the Fed members do learn and adapt. They made changes that boosted the markets and will help the economy.

In 2015, the Fed majority believed the economy could sustain a series of interest rate hikes and further reductions in monetary stimulus. The markets showed otherwise. Shortly after the Fed’s December interest rate increase, investors became concerned about serial bad news from China, weaker-than-expected economic data in the United States and the fallout from the collapse in energy and commodity prices. There were signs of deflation all around the globe. As I said many times the last few years, the greatest risk to the economy and markets is that the Fed might tighten too much, too soon. The Fed almost crossed that line.

Central banks, including the Fed, saw the signs and responded. The European Central Bank announced that it was expanding its monetary stimulus. The Fed at first was more discreet. While still publicly talking about the strength of the U.S. economy and likely interest rate increases in 2016, behind the scenes it was rapidly expanding the U.S. monetary base. Finally, in March, Chair Janet Yellen made clear that the Fed was worried about global factors, especially China, and would be very cautious about raising rates.

The actions from the central banks greatly increased financial liquidity, and global markets quickly reacted. Real interest rates, which were rising, declined. The dollar declined against many currencies. Most assets, but especially stocks and commodities, rallied. The spread between interest rates on treasury bonds and other types of debt decreased. Emerging market assets have done well. The markets were waiting for a catalyst to reverse trends, and they saw one in the fresh injection of global liquidity. Even expectations of inflation, as shown in the breakeven inflation rate, sharply increased.

Another positive factor for the economy is that manufacturing appears to be forming a bottom after the steep decline of the last couple of years. The factors that hurt manufacturing are reversing. The dollar’s rally has at least paused. Commodity prices rebounded a bit. Global growth is increasing, especially in many emerging economies.

These events should lead to higher economic growth. Then, Fed officials again will start talking about raising interest rates, perhaps before 2016 has ended.

Yet, don’t expect a boom in the economy or markets in response to the latest easing. Since 2009, the response to each fresh expansion of liquidity by central banks has been weaker than the previous one. Global economies still need significant changes in fiscal policies to have high and sustainable growth, and there are no signs of that happening.

In the United States, we also need businesses to invest more, instead of using their cash and borrowing capacity to engage in financial engineering.

Investors seem to be less concerned about two issues that dominated the beginning of the year. Most investors now accept that low energy and commodity prices won’t have a domino effect of debt defaults and bankruptcies that would tumble through the global economy.

Also, the panic about China has subsided. There will continue to be problems in China, and the competence of its leadership is in question. But investors now are comfortable with lower growth and even some instability in China.

Also, the panic about China has subsided. There will continue to be problems in China, and the competence of its leadership is in question. But investors now are comfortable with lower growth and even some instability in China.

Despite positive developments, we probably have seen most of the stock rally that’s going to follow the latest stimulus, unless first-quarter earnings turn out to be much better than expected. Earnings growth has been declining, even after excluding the energy and commodity sectors. Lower profit margins and weaker earnings growth are keeping a lid on the U.S. stock indexes.

European stocks look like a better buy at this point than U.S. stocks. European markets have lagged the U.S. markets since the European debt crisis of 2011. European stock prices reflect strong negative sentiment about corporate earnings. Positive earnings surprises in Europe would trigger a strong rally.

The new, expanded quantitative easing by the European Central Bank should help the economy a bit and push some investors toward stocks. Also, it looks like emerging economies are forming a bottom. That should be good for European stocks, because European companies generate substantial portions of their revenues and earnings from emerging economies. The state of emerging economies is more important to many European companies than their home economies.

You can expect high volatility to continue. Investors will continue to overreact to each hint of change in the data and especially in monetary policy. That presents opportunities for other investors.