by Robert Katch

The U.S. economy has now experienced its fourth quarter in a row of flat or lower earnings.  On average, S&P 500 earnings are expected to drop 7% to 8% in the first quarter of 2016. The stock market is likely to stay in a trading range until there is greater confidence that earnings growth is on the rise again.  However, investors recently received even more conflicting data with financial stocks down 3%, the dollar falling, and the continuation of the yen’s unexpected strength.

The yen’s strength has been the subject of much curiosity and confusion to the point where it is generating conspiracy theories about secret deals between our Federal Reserve and those of the E.U. and Japan to weaken the dollar following its 25% rise from mid-2014 to its peak in January 2016.  Foreign exchange is the world’s biggest traded market with $5 trillion changing hands daily.  While it’s not what the average investor focuses on, currency moves impact stock markets.

The yen’s rise makes Japanese exports more expensive and has spooked their stock market which is down 17% since August in dollar terms.  Weakness in Japanese stocks could herald slower global growth, which was recently mentioned by Fed Chair Janet Yellen as one of the main drags on the U.S. economy and an important factor preventing the Fed from raising our interest rates as they would like to.

Our Fed, along with Central Bankers around the world, are working under a model where they raise rates to slow down economic growth/inflation and lower rates to speed it up.  However, results over the past five years, and maybe as long as 20 years in Japan, have shown this is not necessarily the case.  While this model may have worked with “normal” interest rates, as rates have approached zero, unintended consequences have developed.  For example, pension funds such as California’s CALPERS, base its pension payments on estimated future returns of 8%, but when bonds are earning 1% to 2% it may be impossible for stocks to make up the difference.  Pension problems in Detroit, Puerto Rico, and Illinois have been exacerbated by low interest rates.  Imagine the financial issues being created in Germany and Japan where some interest rates are now negative and investors are actually paying interest to invest their money!

So how will this likely play out over time?  Our Fed must raise interest rates slowly over a long period of time, concerned that if they move too fast our economic growth will be stunted.  The Fed talks about “normalizing” interest rates, but this will take 2-5 years if rates are hiked at the currently expected pace of 0.25% twice a year.  In a world of very slow growth causing low returns from both stocks and bonds, investors will need to consider other asset classes and investment strategies to generate sufficient returns.

12-MFI Staff-RobertRobert J. Katch is the founder of Manchester Financial, an Investment Counsel/Wealth Management firm located in Westlake Village. For more information call 800-492-1107.

This material is provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.