Now that taper talk has moved from the realm of rumors to the lips of the Federal Reserve chairman, and stocks and bonds have experienced their anticipated wash-out, investors are wondering about the next stage in the investing year. We expect growth and even acceleration in the U.S. economy to revitalize the stock market and push bonds down further.
Investors may question our optimism on equities; after all, they have not done much better than bonds lately. As of 6/24/13, the S&P 500 had retreated about 6.8% from its late-May peak, while still holding high-single to low-double digit year-to-date gains. In the U.S. Treasury market, the 10-year yield has widened out by roughly 100 basis points in less than two months, briefly topping 2.6%; yields at shorter maturities have risen less but are still substantially higher.
U.S. bonds, in our view, are entering a cyclical bear market. Central banks, in tapering bond purchases, are ending their artificial suppression of interest rates, and bond prices could be turbulent for a year or more. By contrast, we see the dip in stocks as a buying opportunity.
Loose Lips sink Blue Chips
How can we take such different views of these two asset classes, which in the past have sometimes moved together? We believe that stock markets track earnings over the long term, even amid interim distractions from geopolitical events, politics and policy - including central bank programs such as QE. We believe the trend in earnings is intact, even as the composition of growth changes. The contribution to earnings growth from China and the emerging economies has wavered. The growth contribution from the U.S., however, is improving. Possible moderation (we stress possible) in the U.S. industrial economy is being superseded by an ever-more optimistic and free-spending consumer.
The same domestic economic strength that is underpinning corporate earnings progress will cause the Fed to first taper and then cease its purchases of U.S. Treasury debt, in our view. Chairman Bernanke stated that Fed bond buying could begin to wind down in the back half of 2013 and be finished by mid-2014. The prospect of the Fed exiting the Treasury market has already caused yields to back up; the reality of the Fed exiting the Treasury market could be much worse for bond holders.
Each month, the Fed purchases $45 billion in long-dated Treasury debt (along with $40 billion in mortgage-backed securities). On a 12-month basis, that equates to $540 billion in Treasuries. The good news is that in May 2013, the Congressional Budget Office reduced its estimate for the 2013 deficit by 24%, to $642 billion. The bad news, given the above math, is that the Fed is on track to purchase 84% of the Treasury issuance required to fund the deficit in 2013. Prior to the CBO's dial-down, the Fed was on track to purchase 64% of the Treasury issuance required to fund the deficit. Regardless of the definitive and final budget deficit and QE totals, the Fed is the predominant buyer of Treasuries; and there are not enough alternative buyers on the sidelines to pick up the Fed's slack once it exits.
During his now infamous news conference, the Fed Chairman clarified that QE would only be wound down amid clear evidence of an expanding domestic economy. The recovery is only as a good as the latest batch of data; and a flood of data will be released between now and mid-2014. In the interim, we can only examine the data at hand. Recent economic data may indicate some moderation in the industrial economy, likely in response to the down-shift in emerging economies. But it also signals that the consumer recovery continues in the U.S. and may even be accelerating.
A "Normal" Economic Cycle
Given the constantly refreshing tide of new traders and analysts, the financial markets treat every cycle as a brand new thing. In fact, economic up-cycles have always begun with strength in the industrial economy. The consumer, always the last to know when the economy is cratering, also lags in joining the recovery. So we would call this a fairly normal recovery cycle.
The United States is special, with its vast wealth of natural resources and farmlands to complement our industrial might and technology leadership. Given this unique set of circumstances and the twin consumer engines of housing and automotive, the U.S can sustain a domestic recovery for an extended period even amid turbulence in the global economy. We think this consumer-led recovery period is still in early innings.
Before turning to the data, we beg to quibble. We believe seasonal adjustors, introduced to smooth seasonal irregularities, have themselves become the source of data distortions in this era of unsettled climates. Every year during the post-2009 bull market, we have seen a softening in mid-year data, partly reflecting seasonality and partly reflecting these "broken" adjustors.
So far in mid-2013, however, the data has generally remained strong. After the ISM's manufacturing survey fell to 49% - its first sub-50 reading in four years - concerns intensified regarding the industrial economy. Economy bulls were thus cheered on 6/25/13 by durable goods orders, which showed 3.6% growth for May. That beat the 3.0% consensus and matched the 3.6% reading from April (revised up from 3.3%).
Within the Durable Goods report, non-defense capital goods orders excluding aircraft (a proxy for corporate capital spending) rose 1.1%, much better than the survey forecast of 0.5%. Actual shipments of non-defense capital goods excluding aircraft jumped 1.7%, again doubling the 0.8% consensus call. Durable goods orders excluding all transportation rose 0.7% in May, vs. the 0.0% consensus forecast.
A range of regional surveys also seem to refute the ISM's message. Empire (New York State) Manufacturing posted a 7.84 reading for June; that was up from minus 1.43 in the prior month and bested the consensus call of flat. The Philly Fed Survey and Dallas Fed manufacturing activity sharply exceeded consensus expectations (although the Chicago Fed's activity index disappointed). Further refuting the ISM's survey, the Markit U.S. PMI (purchasing managers index) came in at a preliminary 52.2, consistent with expansion.
Consumer-driven data has sent an even clearer message of recovery, led by the housing sector. As noted above, the Fed's monthly QE appetite includes about $40 billion in mortgage-backed debt such as Collateralized Mortgage Obligations (CMOs). Among the Fed's several mandates, the CMO purchases are designed to keep mortgage rates down and encourage continued housing activity. The Fed Chairman has been clear that the Fed will continue to purchase CMOs "indefinitely." The Fed can impact but ultimately cannot stop the higher trend in market interest rates, including mortgage rates. The trend in rates represents a significant threat to the housing economy and bears close monitoring.
That said, the housing data has been universally good. Again going back to the May data that began to be released in mid-June, May Housing Starts rose 6.8% to 914,000 at a seasonally adjusted annual rate (SAAR) from April's revised 853,000 SAAR. Building permits for May backed off the June pace by 3%, but remain healthy at a 974,000 SAAR.
Existing home sales for May rose 4.2% from April to a 5.18 million SAAR. New home sales ran at a 476,000 SAAR for May, up 2% from a (revised) 466,000 SAAR for April. That was the highest level of new home sales in five years (since July 2008). Compared with May 2012, new home sales were up 29%.
Between 1999 and 2005, new home sales consistently represented about 16% of all homes sold. After the recession, the new home market continued falling; May 2010 represented the "low watermark," according to Fortune Magazine, as new homes represented just 5.5% of sales. While both existing and new home sales are rising, new home sales are increasing faster. Based on the May 2013 data, new home sales are on track to represent 8.4% of homes sold this year.
We are not looking for new homes to return to 16% of homes sold anytime soon. But based on the strong housing starts data, we could see this percentage push into double-digits later this year or early in 2014. All housing sales are good for the economy. While new home sales put more construction professionals to work, existing home sales revitalize the formerly moribund realtor business along with refurbishment-sensitive industries (R&R contractors, carpets & curtains, and retail sales in general). But the construction and sale of a new home generates more jobs, more housing materials sales, and more sales of appliances and other durable goods.
The S&P/Case Shiller 20-city home price index rose 12.1% in April, better than the 10.6% consensus forecast. Housing inventory has been low, partly because potential sellers who saw their housing values fall have been waiting for a price rebound to sell. Tight inventories are likely contributing to the strong and rising trend in home prices. As more new homes are built and more owners are willing to sell, housing inventory is improving; inventories increased 2.5% in May, reaching their highest levels since August 2011.
We remain concerned that up to one-third of housing sales are cash-based, which suggests investment-driven purchases rather than families moving into their dream home. Housing for investment may be more rate-sensitive than sales driven by family creation, step-ups, immigrants, and the like. Ultimately, higher mortgage rates will slow all housing activity. But first we should see a typical J-curve pattern of rising activity. During this period of rising rates, we expect to see housing as investment give way to housing as shelter.
A key prop for rising housing activity and housing prices has been the improving employment situation. While the monthly non-farm tally moves around a lot, unemployment claims - particularly the four-week moving average - provide a more stable view of the jobs economy. The continuing claims moving average, which peaked above six million in 2009 and was above four million as recently as 2011, moved (sustainably we hope) below three million as of May 2013.
Working consumers feel better about themselves. The improving consumer mood was exemplified by the June Consumer Confidence reading of 81.4, which was well above both the consensus call of 75.0 and the prior month's 74.3. This marked the highest reading in five years. Like the consumer, consumer confidence is a lagging indicator. But that also means that once it is in a rising trend, consumer confidence - and the spending that goes with it - should prove sustainable.
Conclusion
Higher taxes, the sequester, and rising interest rates all represent challenges for the domestic economy as it seeks to sustain 2.5%-plus GDP growth. The next set of data points may not be nearly as good, particularly if further decline in financial assets reverses the gain in consumer confidence.
For right now, however, the trend in economic data supports growth in the most important market for U.S. companies, which is the United States. Ongoing earnings growth has been correlated with rising stock prices since the bull market began in 2009. We regard the recent indiscriminate selling as a buyable dip in stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
