During the global financial crisis, the US Federal Reserve’s gathering of global central bankers in Jackson Hole, Wyoming transformed from an academic discourse into a platform from which Ben Bernanke set the stage for future monetary policy actions. As the annual meeting convenes again this weekend, Janet Yellen may be hoping to downplay her comments from the market-moving attention that her predecessor’s received. Her topic is on labor. Judging by the equity markets grind higher after the rate hike scare a month or so ago, expectations are for a dovish tone. While unemployment has continued to fall and wage growth recently turning slightly up, Yellen has continued to comment on the slack still evident in the system. The broader “U-6” measure which incorporates workers that are discouraged and part time for economic reasons is one of the supporting data points. While also on a down trend from its peak around 17% in 2009, it remains at relatively elevated at 12%. Others may look to the participation rate. Granted, the participation rate has been on the decline in the US since around 1999, the pace of deterioration accelerated in late 2008. All in all, we do not expect Yellen to say much new and will likely keep comments in line with expectations.
More attention is likely on the keynote speaker, ECB President Mario Draghi. The litany of economic data out of Europe in the past 45 days has been consistently weak. So far, there has been little benefit derived from the raft of initiatives announced earlier this year. Tensions in the Ukraine continue to weigh on economic activity overall. The green shoots of growth are drying out along with the earnings expectations of equities. Only recently has the EUR/USD exchange rate started to decline likely due to an outflow of capital as government bond yields are anemic for the larger, more stable countries like Germany. A weaker currency would be a welcome relief to support exports (as well as give a boost to corporate earnings due to currency translation). Draghi has consistently commented on asset purchases but, like we have said many times before, he needs to “show me the money”. As we have also said, we expect ECB action later this year or early next as the bank finishes up their Asset Quality Review on banks. The reason is that, due to constitutional restrictions on the ECB calling into question buying government debt, we think the ECB may increase the size of their balance sheet through purchase of private assets more akin to the Maiden Lane transactions by the Federal Reserve. These types of transactions would increase enable both an expansion of the ECB balance sheet (and thus monetary base devaluing the euro at the margin) while also de-levering banks enabling flexibility in lending and mutualize some of the bank risk off individual countries.
Our investment process is focused on long-term forward looking views to identify sustainable trends where valuation is attractive, not near-term actions that provide “sugar rushes.” The earlier we are to identify a change in trend, the more risk in being wrong but the more return possible from an eventual re-rating as the new information becomes consensus. In Europe, we initiated our first dedicated investments in the portfolio almost a year ago. Our timing was fortuitous as expectations adjusted up quickly just after our investment leading to strong performance through the end of 2013 and into early 2014. As those expectations proved to be too optimistic in the near-term, we have given back some performance. Through this, we managed the relative risk and return potential through position sizing. Even today, we remain meaningfully underweight relative to a global equity comparison and continue to hold the existing exposure.
We remain focused on the long-term. While we might all like to return to the investing world where the financial markets are not so closely tied to policy decisions, we cannot in the near-term. There is still too much interaction for policy decisions not to make fundamental impacts. Correlations amongst individual equities in the US have started to come down partly due to the maturity of the recovery here and the lull of markets grinding higher. But there is a divergence on a global basis that is set to take hold over the next 3-5 years. Because of its relative maturity, the US is backing off its easy policy. We do not expect it to be quick, of large magnitude, or a surprise but it is coming. On the other hand, Europe has recognized the error of its austerity in prior years. Looking around the globe, economies that have recovered have for the most part been supported by fiscal and monetary policy. Europe is setting the stages for easing judging from the outcomes of the recent round of elections and comments from the ECB. The gap that will be created by US tightening (relatively speaking) and Europe easing benefits Europe (in local currency terms). It is early days still and bumps are to be expected. Talk is cheap as the balance sheet of the ECB continues to shrink, unemployment remains high, and GDP growth flat-lines. Only action will create the trend.