by Jim Welsh with David Martin, Forward Markets

U.S. Economy

The U.S. Commerce Department first estimated that first quarter gross domestic product (GDP) grew 0.2%, but this did not include March trade data as the information was not yet available.In March, the trade deficit rose to $51.4 billion from $35.9 billion in February primarily due to an increase of $17.1 billion in imports.

GDP measures domestic production, so imports are subtracted from GDP since imported goods and services are produced overseas. After including the trade deficit in March and other revisions, the Commerce Department now estimates that GDP contracted -0.7% in the first quarter. It is important to keep in mind that the deduction of imports from domestic GDP is an accounting adjustment that ignores the level of domestic demand for imports. Imports are a response to orders, and orders for goods from overseas are a reflection of domestic demand. In the first quarter, domestic demand was understated due to the accounting adjustment used in the GDP report. This is one reason why we think the economy was in better shape in the first quarter than the GDP report indicates.

According to the Federal Reserve of San Francisco (SF Fed), since 2000 GDP on average has been 2.3% lower in the first quarter than in the other three quarters. This fact has led to criticism of the seasonal adjustment process used by the Bureau of Economic Analysis to produce GDP data. After the SF Fed researchers seasonally adjusted the data, they estimated that GDP rose 1.8% in the first quarter. This past winter was the tenth most severe winter since 1960. We don't need a debate about seasonal adjustments to conclude that GDP will rebound in the second quarter; it's just a little common sense.

After a -2.1% decline in the first quarter of 2014, GDP rebounded strongly in the second quarter 2014 to post a gain of 4.6%. Those expecting a replay this year are likely to be disappointed since the rebound in this year's second quarter will likely be half of what it was in 2014. In the first half of May, reports on retail sales, industrial production, capacity utilization, consumer confidence, producer prices and import prices all came in weaker than expected. Although job growth rebounded smartly from March's increase of 126,000 to 223,000 new jobs in April, the nemesis of this recovery continued. Average hourly earnings rose 2.2% in April, well below the 3.0%-3.5% average growth in the majority of post-World War II recoveries. The spread between the U-3 and U-6 unemployment rates held at 5.4%, indicating that a fair amount of slack remains in the labor market. Until this spread narrows to less than 5.0%, wage growth is likely to remain muted in coming months.

Last month we referenced an estimate by reinsurance company Swiss Re that U.S. savers have received $470 billion less in interest income since 2008 due to the Fed's zero interest rate policy (ZIRP). We surmised that this Fed policy was also affecting those within 10 years of retirement. The nest egg that seemed large enough to provide a comfortable retirement a few years ago doesn't look sufficient based on the low level of interest rates in the past seven years. This realization is leading some baby boomers to cut back on spending and increase their savings to make up for the reduced income they now expect from their nest egg. It is also resulting in a greater percentage of workers needing to delay retirement or deciding to work well after the normal retirement age of 65. According to the U.S. Department of Labor, the percentage of workers aged 55 to 59 that were working in April compared to January 2000 has increased from 69.7% to 71.5%, a modest increase of 2.6%. But the percentage of workers aged 65 to 69 that are working has jumped from 23.2% to 31.7%-an increase of 36.6%. This is not how many of the 76 million baby boomers expected to enjoy their golden years.

Between June 2014 and January 2015, the Consumer Confidence Index soared from 82.5 to 98.1. This surge in confidence coincided with the 44% plunge in gasoline prices from a national average of $3.684 on June 25, 2014, to $2.033 on January 25, 2015, according to the American Automobile Association. Clearly the $10-$15 a week most consumers were not spending to fill up their tanks made them feel better, but according to Visa they only spent 25% of these gas savings. Since bottoming in January, gasoline prices have rebounded 33% to $2.700 as of May 17, but are still down -26.7% from last June. In California, gasoline prices fell 40.0% from June 2014 until January 26, increased 52.0% since then, and are only down -10.7% from last June. Why? An explosion on February 18 at the ExxonMobil refinery in Torrance, California, caused prices to jump throughout the state. The refinery produced 1.8 billion gallons of gasoline in 2014, almost 10% of California's supply. Because California mandates its own specific gasoline blend, gasoline cannot be imported from other non-California refineries. If gas prices were 26.6% (comparable to the national average) less than the $4.13 average California gas price last June, Californians would be paying around $3.20 a gallon instead of the $3.73 they are paying as of May 11-and up to almost $4.00 a gallon in San Diego.

Although the dollar corrected 7% from its mid-March high, it is still 20% above levels a year ago and continues to be a headwind for U.S. exports. The strength in the dollar and weakness in other currencies are also making imports more competitive with U.S. domestic producers. Over the last year, nonenergy import prices have fallen -2.3%, which gives importers a price advantage. If domestic producers want to maintain market share, they will have to lower their prices and lower their costs to maintain profit margins.

We do not expect second quarter GDP to exceed 3% as forecasted by many economists and strategists. Stagnant wage growth, below average business investment and the export headwind from the stronger dollar is likely to keep second quarter GDP growth to less than the 2.36% average annual growth rate since June 2009.

U.S. Federal Reserve

Our view has been that economic growth was going to slow in the first half of 2015 and that the Fed would not raise rates in June. Although this view placed us in the distinct minority back in January, we thought there was simply too much slack in the labor market to expect wage growth to pick up before June based on the spread between the U-3 and U-6 unemployment rates. Wage growth has not improved this year even though the U3 has declined from 5.7% in January to 5.4% in April. The Fed has repeatedly said that it is data dependent. In speeches and interviews during the past year, the majority of Fed governors have stated they were against raising the federal funds rates unless economic data came in stronger than expected. Even though first quarter data came in weaker than expected, a number of Fed members, including Fed chair Janet Yellen, have dismissed the weakness as being transitory. We think these comments underscore a subtle shift among a number of Fed governors toward raising rates before the end of 2015 unless second and third quarter data is too weak to justify even a 0.25% increase.

This is an important distinction. We think a majority of Fed governors now want to end the zero interest rate policy that has been in effect since 2008. If the economy can't handle a 0.25% rate increase, then it really doesn't matter what the Fed does, but one rate increase would mute some of the criticism they continue to receive for maintaining ZIRP. For a number of Fed governors, one small increase before the end of 2015 may ensure they won't have to raise rates rapidly should inflation ramp up in 2016 or 2017. One increase before the end of 2015 would allow the Fed to stretch out rate increases over a longer period of time, thus lowering the threat to the economy from a faster pace of rate increases. We have no idea whether the Fed will raise rates in September or some other month before year-end, but the shift in their bias is noteworthy. After all, the Fed is data dependent.

The Weakest Post-World War II Expansion

The National Bureau of Economic Research (NBER) is the official arbiter of the business cycle under a contract with the U.S. Department of Commerce. The widespread understanding is that the definition of a recession is two consecutive quarters of contraction in GDP. While this definition is close to the mark, NBER uses a broader definition to define the business cycle:

a "significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales."

By measuring a wider range of economic data, a more accurate assessment of the economy can be gleaned than just focusing on GDP alone. Many of the additional data series utilized by NBER are reported monthly, compared to GDP, which is reported quarterly and often with significant revisions. Incorporating monthly data allows NBER a higher level of precision. In the majority of post- World War II recessions, GDP did contract in two consecutive War II. It will potentially become the fourth longest expansion in August when it exceeds the November 2001-November 2007 expansion, which lasted 73 months. The average length of the 11 expansions since World War II has been 63.5 months. The shortest expansion lasted 24 months and the longest 120 months.

To compare the strength of each expansion irrespective of length, we calculated how much GDP grew each month during each of the 11 post-World War II recoveries (expansion that began in 1945 is not included in the chart). We used quarterly GDP data to determine the length of each expansion, which increased the average expansion to 63.9 months from the NBER calculation of 63.5 months. This modest variance is primarily due to the use quarters, but one of the exceptions occurred in 2001 when GDP contracted in the first quarter, rose in the second quarter and fell again in the third quarter. NBER determined that a recession began in March 2001 and ended in November 2001. In total, GDP only contracted -0.07% from peak to trough during the 2001 recession.

There is often a lengthy lag time between when a business cycle changes and when NBER announces it. NBER didn't announce that a recession had begun in December 2007 until November 28, 2008, and waited until September 20, 2010, to confirm that a recovery started in June 2009. Based on NBER data, the recovery that began in June 2009 is the fifth longest of the 11 expansions since World of quarter-end dates (because of GDP data release dates) rather than the intraquarter month-end dates used by NBER. The total percentage increase in GDP during each expansion was calculated by the difference between the level of GDP at the beginning of each expansion and the level of GDP at the end. We were able to estimate how much the economy grew each month during each expansion by dividing the total percentage of GDP gain by the number of months an expansion lasted. For instance, between September 1982 and June 1990, GDP increased from $6,486.8 billion to $8,981.7 billion, a gain of 38.46%, and the expansion lasted 93 months, so the average monthly increase in GDP was 0.414%. The average monthly increase in GDP during the 10 expansions prior to 2009 was 0.447%. The current expansion has averaged a monthly GDP increase of 0.197%, which makes it less than half as strong as the 11 recoveries since World War II despite its longevity. The expansion since June 2009 has grown at an average annualized rate of 2.36% compared to an annual increase of 5.36% for the other 10 post-World War II expansions.

While the current recovery has been the weakest post-World War II expansion, the September 2001 expansion was certainly no barn burner either, growing at an annualized rate of 2.93%. What makes the lack of strength during the last two expansions so puzzling is monetary policy could not have been more accommodative. The real federal funds rate has been negative since April 2008 and is likely to remain negative until the Fed raises it above the core rate of inflation, which was 1.8% over the past year. According to NBER, the economy emerged from the 2001 recession in November, but the recovery didn't really pick up steam until the spring of 2003 when a cut in taxes gave the economy the spark it needed to lift consumer and business confidence. This partly explains why the Fed kept the real federal funds rate negative from October 2001growth has been lower and each trough in the real federal funds rate has been lower and gone negative for a longer period of time.

Numerous headwinds have combined to neuter the impact from lower interest rates. Debt as a percentage of GDP has doubled, rising from 165% in 1981 to 330% in 2015 after peaking above 360% in 2007. The cumulative increase in debt since interest rates peaked in 1981 borrowed demand from the future and levied a drain on cash flow that has diminished current demand. Household debt grew from 44% of GDP in 1981 to 98% in 2007.

Although household debt is now down to 80%, the majority of the improvement came from consumers defaulting on mortgages and credit card debt rather than paying down debt from higher incomes.The cumulative impact of compliance regulations over the past 50 years has raised the cost of doing business as well as the cost of implementing those regulations. The Competitive Enterprise Institute estimates that regulation will cost the American economy $1.882 trillion in 2015, or close to 10% of GDP. A 2012 study by until December 2004. As illustrated by these past two recessions, monetary policy has been losing its potency to generate GDP growth for more than 30 years. Since 1981, each peak in GDPNERA Economic Consulting found that the number of major regulations in the manufacturing sector grew at an annual rate of 7.6% since 1998 compared to annual GDP growth of 2.2%. In the World Economic Forum's annual "Global Competitiveness Report," the U.S. ranked second of 144 countries in the "Burden of Government Regulation" category. Some of the regulatory burden is offset by the accrued economical benefits from cleaner air, safer work environments and a safe food supply, which should not be overlooked. Another headwind to global competitiveness has come from globalization, which resulted in middle-class jobs being exported overseas. The benefit of cheaper imports that this created is easily outweighed by the loss of jobs. Technology innovation provided a significant lift to the economy in the 1980s and 1990s, but it has eliminated more jobs than it has created over the last 10 years, particularly routine manual jobs, as we discussed last month.

The Federal Reserve doesn't have control over these headwinds but by maintaining interest rates near zero for so long, a decline in business investment has been one of the unintended consequences. According to the Bureau of Economic Analysis, private investment net of depreciation was $524 billion in 2013 (the latest available figure), far less than the $860 billion in 2006. Over the last decade, companies have spent less than half of their cash flow on capital investment and more on dividends and stock buybacks, according to Bank of America Merrill Lynch. In recent years, the percentage of corporate cash going to stock buybacks and dividends has accelerated significantly. In 2014, companies spent $564.7 billion on share repurchases and $349 billion on dividends, which represented more than 95% of cash flow. In April, companies announced a record $141 billion in stock buybacks. In pursuit of shareholder value maximization, corporate boards have directed cash flow away from investments in plants and equipment for years. As a result, the average age of fixed assets in the U.S. reached 22 years in 2013, the highest level since 1956, according to the Commerce Department. The diversion of cash flow to shareholders and away from employee earnings has pushed wages as a percentage of GDP to the lowest level in 50 years. Over the past 15 years, this strategy has been great for shareholders and profit margins, but the short-sightedness of shareholder value maximization has not been good for economic growth or productivity.

Data from the Bureau of Labor Statistics show that annual productivity grew 3.3% between 1948 and 1973 and 3.2% between 1996 and 2004. Between 2005 and 2014, productivity growth slowed to an annual increase of 1.5% and has risen just 0.7% each year since 2011. In the first quarter of 2015, productivity decreased at a -1.9% annual rate after dropping -1.8% in the fourth quarter of 2014. During the last 25 years, productivity has contracted in two consecutive quarters only three times. The extraordinarily weak growth in productivity coincides with companies failing to invest in new equipment to increase productivity. An extended period of low productivity could have a profound effect in coming years on the standard of living of working Americans and the ability of the U.S. to compete in a global economy.

The U.S. now ranks twelfth among developed nations in terms of business activity, behind countries like Hungary, Denmark, Finland, Sweden, Israel and, believe it or not, Italy. For the first time in more than 40 years, fewer firms opened their doors for business compared to those that closed based on Census Bureau data from 2012 and 2013. This decline in business activity is not happening because money is too expensive or not available. Startup businesses account for 20% of job creation, so making it easier and less expensive to start a business should be a priority. We have no doubt that uncertainty in the wake of the financial crisis dampened people's willingness to take on the risk associated with starting a business, but we are almost seven years removed from the financial crisis and interest rates have been near zero since 2008. The hurdle of government regulation has certainly played a role since it delays when the doors can be opened for business and raises compliance costs once a business is open.

Many of the reasons why this is the weakest post-World War II recovery predate the financial crisis, suggesting fiscal, monetary and business policies have been drifting off course for at least 30 years. A comprehensive review of regulations that inhibit growth is necessary. For instance, there are 18 different blends of gasoline mandated within the U.S. Since a new refinery has not been built in more than 45 years, the safety margin of supply is small. When an accident occurs, as one recently did in California, the price of gasoline soars because California has mandated consumers use a cleaner-burning fuel, precluding California from using gasoline produced anywhere else in the country. Common sense would suggest that the number of gasoline blends be reduced from 18 to 3, or even 1, so any temporary supply shortage can be addressed quickly, minimizing any negative economic repercussion.

Corporations need to get back to the business of investing in their future and our country's future so the U.S. remains globally competitive. The Fed's zero interest rate policy has not spurred demand as in prior cycles and one of the primary reasons is weak wage growth. Corporations need to increase the compensation of their workers so employees can spend more and save for their retirement. Although profits would likely fall from their current all-time highs in the short run, some of the profit reduction would be recouped from the boost to economic growth from increased business investment and more spending by higher paid workers. Henry Ford was a genius for inventing the assembly line, but his real genius was paying his workers enough so they could buy the cars his assembly lines produced. The minimum wage has been increased by a number of states, cities and companies and will provide a small lift to overall wage growth. According to the Pew Research Center, just 3.3 million workers, or 2.6% of all wage and salary workers, worked at or below the federal minimum wage in 2013. A $3 an hour increase for workers who work 29 hours per week will add approximately $4,000 more per year to their incomes while a typical oil worker earns $75,000 per year. The increased earnings for 18 minimum wage workers is the equivalent of what one oil worker earns, so the loss of 68,000 energy jobs offsets the income gain of more than 1 million minimum wage workers. Although only 2.6% of the labor force earns the minimum wage, just as a tide lifts all boats, the increase will likely lift the wages of workers earning just above the minimum wage as well. According to the Bureau of Labor Statistics, 29.4% of workers are paid wages that are below or equal to 150% of the minimum wage in their state. This means up to 35 million workers may partially benefit from a nationwide increase in the minimum wage.

Since 50.4% of minimum wage earners are 16 to 24 years old and 24% are between 16 and 19 years old, we like the concept of a two-tiered minimum wage. Young workers between 16 and 19 years old, who are getting their first work experience and still in high school, would be paid a much lower minimum wage so employers would not be discouraged to employ them. Workers over 20 years old, who may be working to fund college or support a family, would receive a higher minimum wage. We acknowledge that there could be unintended consequences. A large increase in labor costs will squeeze some small businesses too much and likely result in closures and a loss of jobs. Overall though, it is better that demand within the economy is boosted by income growth paid by companies for work and not from more government spending funded by higher taxes or more debt.

The Federal Reserve needs to move away from the manipulation of financial assets as their primary policy tool. According to Morgan Stanley Investment Management, stocks, bonds and homes have never been so overvalued at the same time in the past 50 years as they are now. Stocks were overvalued in 2000, and prior to 2008 stocks and housing were overvalued. Bond valuations have also become extended in recent months. Fed Chair Janet Yellen has given speeches lamenting the level of income inequality in the U.S., but monetary policy has played a significant role in recent years in widening this inequality. The ratio of CEO-to-worker compensation has soared from 20-to-1 in 1965 to nearly 300-to-1 today. Unless there are meaningful changes, the risk that the new normal will become our long-term reality will continue to rise.

Eurozone

The recovery in the eurozone strengthened in the first quarter of 2015 with year-over-year GDP growth rising 1.0% versus 0.9% in the fourth quarter and 0.8% in the third quarter of 2014. Quarterly annualized growth was 1.6% in the first quarter compared to 1.2% in the fourth quarter, so the rate of improvement accelerated in the last two quarters. It is also constructive that the first quarter improvement was more broad-based than in the fourth quarter. In the fourth quarter, Germany contributed 58% of the gain in GDP, double its 29% GDP weighting in the eurozone. In the first quarter, Germany's contribution was in line with its GDP weighting, even as Germany's GDP growth slowed to 1.0% from 1.5% in the fourth quarter. Year-over-year growth in France rose to 0.7% in the first quarter versus no growth in the fourth quarter while Italy improved to 0% growth from a contraction of -0.5% in the fourth quarter. On May 19, the European Central Bank (ECB) said it would increase the amount of its monthly bond purchases during May and June since there is less bond trading from mid-July through August due to the summer holiday. While that may be true, we suspect the timing of this announcement had more to do with tamping down yields and the value of the euro. Between April 21 and May 15, the euro rallied from 1.0667 to 1.1472 and the yield on the German 10-year bund rose from 0.05% to over 0.70%. In the wake of the May 19 ECB announcement, the euro weakened and yields fell. This smells like another example of market manipulation by a central bank.

The improvement in first quarter GDP was assisted by a weaker euro, historically low bond yields throughout the European Union (EU), lower oil prices and an improvement in bank lending.

However, the good economic news of the first quarter has deteriorated since the beginning of the second quarter. As of May 15, the Citi Economic Surprise Index has fallen from 62 to 2 as recent reports have undercut forecasts. Some of this weakness may be attributed to the rally in the euro (from under 1.05 in mid-March to above 1.14 on May 15), the uptick in yields and the rebound in oil prices.

Despite the short-term improvement in economic activity in the first quarter, the long-term structural problems that have plagued France and Italy have not been addressed. On May 13, Valdis Dombrovskis, vice president of the European Commission, said:

"Many member states face challenges such as high public and private debt, low productivity and lack of investment, which result in high unemployment and worsening social conditions."1

The unemployment rate in the EU was 11.3% in March. As part of the European Commission's annual recommendations, France and Italy were singled out and encouraged to exploit the recovery to loosen rigid labor markets and lagging competitiveness. Neither country is likely to enact meaningful reforms in 2015 to address these issues. We expected GDP in the eurozone to grow about 1.5% this year, so we don't expect it to accelerate much.

Euro

We suggested shorting the euro in the May 2014 Macro Strategy Review (MSR) when the euro was trading above 1.380. In mid- March 2015, sentiment toward the euro was uniformly negative and talk of the euro falling to parity with the dollar (1.00) was rampant. As we noted in the April MSR, when extreme forecasts are made after a market has experienced a large advance or decline, it is time to expect a counter-trend move. Fundamentally, we thought the dollar would weaken as the timing of the first interest rate hike was pushed back from June and better economic news in the eurozone encouraged a shift in sentiment and short covering in the euro. In the April 2015 MSR, in anticipation of a rally to 1.110-1.150, we suggested covering a portion of the short position when the euro went under 1.065, which it did on April 14 and 15.

According to the Commodity Futures Trading Commission, as of May 15 short positions held by hedge funds and other investors have fallen to their lowest level since December after declining for seven consecutive weeks as traders covered their short positions. The Daily Sentiment Index for the euro had risen to 85% bulls by mid-May compared to the single-digit percentage of bulls in early March. There is a good chance the high of 1.1472 on May 15 marks the high of the euro rally. As this is being written on May 22, we expect the euro to test the mid-March lows in coming months. Any move above 1.1472 would not alter our negative longer term outlook.

China

In mid-April, China reported that first quarter GDP was 7.0%, the second slowest reading since 2001. While China can say growth was 7.0%, actions speak louder than words and recent actions suggest economic growth has slowed more than China is willing to acknowledge. The People's Bank of China (PBOC) has cut interest rates three times, with the latest 0.25% reduction on May 10 lowering the one-year benchmark lending rate to 5.1% from 6.0% last November. The rate cuts have failed to spur an increase in lending since Chinese companies and local governments are already struggling to repay outstanding loans. After announcing the rate reduction, the PBOC was unusually frank in its monetary policy report:

"Rising debt size is forcing China to use a lot of resources in repaying and rolling over debt."2

As we discussed in our April MSR, China's total debt has almost quadrupled from $7.4 trillion in 2007 to $28.2 trillion in mid-2014, raising its debt-to- GDP ratio from 158% to 282%. Each new dollar of debt now only generates $0.20 of GDP compared to $0.80 in 2007; each new dollar of debt will get less bang for the yuan.

To address the burden of trillions of dollars of debt held by local governments, China's Finance Ministry issued a directive marked "extra urgent" in early May. The plan will allow local banks to purchase local government bailout bonds in exchange for low-cost loans from the PBOC and provide Chinese banks with cheap money to make new loans. As we have discussed often, China suffers from too much debt and too much excess capacity, which has led to deflation, as measured by producer prices. This plan will result in more debt and more capacity and is hardly a solution to the country's real problems. Although it may delay the day of reckoning, sooner or later China will have to absorb significant credit losses and debt restructurings that will impair its banking system.

Economic activity in April weakened further, which likely prompted the sense of urgency. Fixed asset investment, which includes investments in factories and buildings, rose 9.6% from April 2014, the slowest pace since December 2000. Retail sales grew only 1% in April from a year ago and M2 money supply expanded 10.1%.

The growth rate in both series was the lowest in a decade. In the April MSR, we said we expected more cuts in interest rates and the reserve ratio and doubted the rate cut in May would be the last. We don't think recent "extra urgent" actions will be enough to accelerate growth in coming quarters. The only uncertainty is whether China will be willing to report GDP growth under 7.0%.

Oil

Since we believe Q1 reports understated actual GDP growth in the U.S., the rebound in Q2 will represent more of a statistical bounce than a real pick-up in demand. The weakness in the Citi Economic Surprise Index for the EU suggests growth is not likely to pick up much beyond the 1.6% rate in the first quarter and may actually soften in the second quarter. The aggressive easing steps by China may help stabilize GDP growth near 7.0%, but it is not likely to lead to stronger growth. While growth in emerging countries may improve modestly, many countries will struggle with dollar- denominated debt, which increased from $6 trillion in 2009 to $9.2 trillion in September 2014. The increase in the value of the dollar since May 2014 will weigh on growth since it increases debt service and the overall burden of dollar-denominated debt. Global growth is not likely to accelerate much in the next two quarters, so it's hard to expect a material increase in the demand for oil.

Statoil vice president Bjorn Otto Sverdrup recently told the New York Times:

"There is a proverb in Norway that says necessity teaches the naked woman how to knit."3

With oil prices down more than 40% from last June, oil companies have taken up knitting. Using drilling rigs that can move on tracks, oil companies are drilling and completing up to eight wells on a production pad and slashing the time it takes to complete each well from 21 days to 17 days. Using fiber-optic sensors thousands of feet below ground, shale operators are able to analyze data and rocks in real time. This allows producers to be assured that one well is not draining oil from an adjacent well and that all the oil in a formation is captured. Pumps that previously operated 24 hours a day are now turned off and on by new algorithms that measure the flow of oil. These advances in technology have reduced pump fuel consumption up to 20% and lessened maintenance and repair costs, lowering the cost of production by $2 to $3 a barrel. A year ago the cost of production for most shale oil fields was $75 a barrel. After a year of innovation, the cost of production has fallen to $60 a barrel and could fall to $50 a barrel as the pace of cost- cutting innovation continues.

With production costs falling, more shale oil production is profitable, which means production cuts are likely to be less than forecasted in coming months. Although the number of rigs in operation has plunged from 1,609 in October 2014 to 668 in mid-May, oil production in the U.S. is holding up. In April, crude production in Saudi Arabia hit a new high of 10.3 million barrels a day. If demand fails to increase and supply does not drop much, the imbalance that caused oil prices to plunge last year is likely to lead to another sell-off that at least tests $45 a barrel. In the April MSR, we thought it possible for West Texas Intermediate (WTI) crude oil to rally to $55 or even $59 a barrel. In the May MSR, we refined the target to $62 a barrel based the June contract and on how the C-leg of the A-B-C rally from the December low had unfolded. This target was achieved on May 6 after oil popped above $62 a barrel and then reversed lower. Although it is possible for WTI to make a higher high, we think the fundamentals of supply and demand will win out.

Bonds

We expected that the economy would slow in the first half of 2015 and that the high level of labor market slack, as measured by weak wage growth and the U3-U6 spread, would postpone a June rate hike by the Fed. Even though we expected growth to pick up in the second quarter, we didn't think it would be enough for the Fed to raise rates in June. This forecast was confirmed by the April 29 Federal Open Market Committee meeting minutes and by a speech to the Greater Providence Chamber of Commerce on May 22 by Fed chair Janet Yellen. In her speech, Yellen touched on a couple of our major themes: labor market slack and weak wage growth.

"Even with the significant gains of the past couple years, it is only now, six years after the recession ended, that the labor market is approaching its full strength. I say 'approaching' because in my judgment we are not there yet...The generally disappointing pace of wage growth also suggests that the labor market has not fully healed."4

In the May MSR we discussed the high levels of debt relative to GDP around the world, which is why central banks are likely to be limited in how much and how fast they will be able to raise rates in coming years. We concluded that interest rates are likely to remain low for longer than most expect. In her May 22 speech, Yellen said it could be "several years" before the federal funds rate is back to a level the Fed would consider normal in the long run. If the Fed is successful in getting the personal consumption expenditure, its preferred inflation measure, back to 2.0%, the "normal" federal funds rate would be 3.75% to 4.00%. We are skeptical that the rate will approach 3.75% in the next five years. With total debt still so high, the resulting increase in debt service would so significantly slow economic growth as to preclude an increase to 3.75% from happening.

Since the beginning of this year, we thought the yield on the 10- year U.S. Treasury bond was likely to remain range-bound between 1.650% and 2.200%. However, last month we said a close above 2.170% would be a warning sign that the trading range may be ending. On May 5, the yield rose to an intraday high of 2.200% and closed at 2.176%-on its way to an intraday high on May 12 of 2.366%. It is interesting to note that the increase in the yield was not driven by stronger economic data in the U.S., but by a rally in the euro that caused yields in Europe to rise.

Despite the increase in volatility, the yield has yet to close above the trend line connecting the intermediate high yields in December 2013 and September of last year. The horizontal trend line on the nearby graph connects the point where the yield bottomed in August 2013 and where it topped out last November. The intersection of these trend lines conveys the importance of the range between 2.300% and 2.400%. From the low on January 30, 2015, the yield rose from 1.651% to 2.259% on March 6, a difference of 0.608%. From the low of 1.843% on April 6, an equal rally would lift the yield to 2.451%. There is the potential that investors overreact if the economy rebounds modestly in the second quarter as we expect and the yield on the 10-year Treasury bond spikes to 2.451%. We would expect the yield to decline from this level, but we would consider a close above 2.550% to be a longer-term negative.

Stocks

For most of the last four years, whenever economic reports were a disappointment, investors would take heart that the Fed would continue with quantitative easing (QE) and the stock market would rally. The Fed ended its QE program last December, so weak economic reports are not embraced as good news as they once were. If the economy rebounds as we expect in the second quarter, the bullish sentiment generated by an improving economy will be tempered by the realization that the Fed will raise rates. With this as the fundamental backdrop, we think the upside is fairly limited, especially since the market is expensive.

The advance-decline (A/D) line is one of the better technical indicators since it measures whether the majority of stocks are participating in a rally or not. The A/D line has usually weakened before a market top is recorded as it did in 2007 and numerous other instances going back to 1928. The A/D line can also warn of intermediate declines. It broke below its rising trend line on May 5 and failed to make a new high on May 21, when the S&P 500 Index recorded a new high. This pattern is very similar to last year when the S&P 500 made a new price high on September 18, 2014, and the A/D line was lower than its August 29 peak. After the A/D line broke below its rising trend line on September 19, the S&P 500 quickly lost 6.9% by October 15.

In addition to the weakness in the A/D line, the Major Trend Indicator failed to confirm the new high in the S&P 500 by a wide margin and the number of stocks making a new 52-week high has contracted considerably since March 20. The Dow Jones Industrial average (DJIA) exceeded its prior high of 11,289 on May 19, but the Dow Jones Transportation Average (DJTA) was 8% below the peak it made in late November. This is the first time in the last 100 years that the DJIA made a new all-time high as the DJTA was setting a new six-month low. The DJTA was not the only average to come up short as the DJIA was making a new high. The Dow Jones Utility Average, Russell 2000 Index, the NASDAQ-100 Index and NASDAQ Composite Index also failed to confirm the new high in the DJIA. When a car is running smoothly, all of the pistons are working together. When the market is truly healthy, all of the major market averages jointly make new highs. When they fail to do so, it is a sign of stress and vulnerability, which increases the probability of a 4%-7% decline. If a decent reason to sell stocks appears, the market could be vulnerable to a decline larger than 10% by Halloween.

We have thought the S&P 500 could rally to 2,140-2,160 before the market would become vulnerable to a 4%-7% correction. The S&P 500 reached 2,134.72 on May 20 and has reversed. As this is being written on May 26, the S&P 500 is trading just above 2,100. With the technical health of the market weakening, it's important to pay attention to the support levels in the S&P 500. A close below 2,065 would suggest that the odds of a decline to 1,970 have increased.

1. European Commission press release, "Country-specific recommendations 2015: Further efforts needed to support a robust recovery," May 13, 2015.
2. Lingling Wei, "China Cuts Interest Rates as Economic Growth Slows," Wall Street Journal, May 11, 2015.
3. Clifford Krauss, "Drillers Answer Low Oil Prices With Cost-Saving Innovations," New York Times, May 11, 2015.
4. Janet Yellen, speech at the Providence Chamber of Commerce, Providence, Rhode Island, May 22, 2015.