Interest rates will stay close to zero until end of decade

David Levy from the Jerome Levy Forecasting Center senses new trouble for the world economy, a warning that investors should take seriously.  

Levy correctly predicted the economic crisis of 2007, and his grandfather warned in advance of the great market crash in 1929. 

The name Levy seems to go hand in hand with reliable economic predictions. David Levy, chairman of the independent Jerome Levy Forecasting Center (www.levyforecast.com), has successfully followed in the footsteps of his grandfather Jerome Levy. 

But the publisher of “The Levy Forecast,” described as the oldest publication for economic predictions in the U.S., is not only a reliable forecaster, he also knows how to use his knowledge in practice by advising institutional investors as well as non-financial companies. A hedge fund he founded in 2004 achieved more than 500 percent net return until it was closed in 2009. 

Looking forward to 2015, David Levy again takes a skeptical view. In an interview with the Cayman Journal he explains his reasons and how investors should position themselves. 

  

Mr. Levy, until the end of 2015 you forecast a 65 percent risk of a recession even in the U.S. What will cause such a development?  

Our view is simply that problems will develop in the global economy, particularly in the emerging markets. This concern has even further increased during the course of the year. Cheap oil will probably not change that view. Among other things, we are concerned about China. But also in Europe we find symptoms of a contained depression. In our opinion, emerging markets and China will probably enter a recession at first. If the world is to escape economic downturn in 2015, the three threats to the international economy – the euro area, China and the emerging market (EM) sector – will need support on several fronts to last through 2015.  

In China we are worried by a total debt of 190 percent compared to the gross domestic product. This debt ratio is in relative comparison higher than in the U.S., where we saw the peak at 170 percent. Particularly distressing is the pace of the increase, since five years ago the level of indebtedness was only at 115 percent.  

Moreover, a lot of money has been spent on capital assets. This has resulted in a lot of overcapacities. That applies to other emerging markets too. In that context it is critical that the export model these countries were relying on does not work without frictions anymore since the crisis started. As in the case of China, efforts are being made to switch to a more domestically orientated business model. But such a transition is not easy to accomplish.  

The government in China can try to support the economy, but sooner or later the problem will become noticeable. With regard to Europe, the problems are compounded by existing overcapacities and political complications.  

 

The USA presents itself in better shape. Why do you nevertheless refuse to believe in an interest rate turnaround?  

In theory, everything is possible, but in our view the interest rates will stay low for a much longer time. Significant increases are likely prevented by the economic slowdown that we expect worldwide. The whole system is simply too weak and unstable to cope with significantly higher rates.  

Particularly sensitive are the emerging markets. Whenever the yields of 10-year U.S. government bonds moved towards 3 percent, financial turbulence was triggered there. That has simply to do with the foreign capital these countries still heavily depend on. Finally, we anticipate the key interest rates in the U.S. to remain close to zero until the end of the decade. 

 

To what extend do the current stock market valuations play a role in your considerations?  

To answer this, it is important to understand that the valuation ratios in the U.S. have changed fundamentally. While before 1990 the price earnings ratio of the overall market hardly went over the threshold of 20, that has happened much more often in the following years. That is connected to the extremely expansive interest rate policy the U.S. central bank has applied since then. The interest rates were lowered on and on, and in relation to bonds, this justifies higher valuations for stocks. 

Furthermore, the attitude of many investors has changed. Previously they acted more defensively, and stocks were mostly bought only at a valuation discount. Nowadays the belief in constantly rising stock prices is considerably more pronounced. Below the line, the valuation of stocks definitely is relatively high now. But this will have a noticeable negative effect only when economic difficulties occur.  

 

Earnings margins are generally regarded as very high. Why do you see that differently?  

There are many common errors made when assessing aggregate profit margins as opposed to looking at margins for individual firms. First, margins are commonly measured improperly, and therefore their breadth relative to past history is exaggerated.  

By our measures, profit margins are certainly large and the widest in years, but they are by no means at record levels. Second, and more important, the aggregate profit margin should not be considered to be an independent random variable that reverts to its historical mean according to simple probability theory. Rather, the aggregate margin is a reflection of the behavior of the profit sources, the specific transactions in the economy that generate aggregate profits. Profit margins may remain in a relatively high or low historical range for extended periods. Third, although margins are indeed wide relative to past history, profits are low relative to corporate equity, which is what ultimately concerns investors and therefore managements. 

In the present environment of low growth in demand and output, ample idle capacity, elevated equity valuations and limited expectations for the future, investors and business executives are unwilling to expand.  

They are also deterred from investing in more efficient technology because they already have sunk costs in existing facilities. Executives also perceive that margins are critical for maintaining their profits and equity values, so they are extremely protective of margins and are loathe to add to overhead. The result is the juxtaposition of strong profits and wide profit margins against weak net investment and hiring. Business reluctance to invest and hire in the latest U.S. business cycle has resulted in poor profits and poor GDP performance, causing the federal deficit to become extraordinarily wide – sufficiently wide to remain a huge support for profits. 

How should investors position themselves in the context of a contained depression?   

Favor U.S. Treasury bonds and certain other high-quality government bonds over the next 12 months or longer. The periodic financial disruptions that accompany balance sheet shrinkage will continue to encourage flight to safety – to the most stable currencies and government bonds. Such bonds preserve capital and are one of very few assets to appreciate in a deflationary environment. 

At this point in the contained depression, the U.S. economy has made more progress than most of the world in cleaning up balance sheet excesses (although it still has a long way to go). There are also many parts of the global economy (chiefly the emerging markets) that are limited in their abilities to enact countercyclical policies and to preserve their own financial stability during a global downturn.

Therefore, we expect the U.S. will continue to outperform global markets in the balance of the present expansion, during the next global recession, and likely in the ensuing recovery. This is not to say that U.S. equities are a good bet, but rather that they will outperform foreign rivals. In our own portfolios, we are long on the U.S. dollar and U.S. equities while shorting EM currencies and equities. 

 

Is gold a means to protect a portfolio?  

Avoid gold and other commodities. Gold is a poor store of value over long periods of time, and it does not perform well in a deflationary global economy. Gold may perform well in an inflationary environment, but that has little relevance in the foreseeable future.  

More importantly, gold may do well against some unstable currencies, but it is likely to underperform versus the dollar or even the euro. 

David-Levy

David Levy

David-Lev-bb

David Levy

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