The investing world is full of unforeseen consequences. When Fed Chairman Ben Bernanke spoke of winding down QE at his fateful press conference on 6/19/13, the bond market predictably tanked. Stocks wobbled too; but just a few weeks later, stocks have righted themselves. More than 70% of stocks trade above their 200-day (trading 9-month) moving averages. Equity investors are riveted, not by more Fed talk, but by the upcoming earnings season.
Beyond the carnage in the bond market, the biggest change in the investing landscape has been the trend change in the U.S. dollar. Against a trade-weighted basket of currencies, the dollar is approaching a three-year high. The Federal Reserve's Trade Weighted U.S. Dollar Index: Broad has been in a notable rising trend. The uptrend has intensified since the Fed's June 19 press conference, but actually began back in August 2011. At that time, the dollar bottomed following the debt-ceiling debacle. Just since mid-June, the dollar has gained 4.2% against the euro.
Dollar strength has worsened the decline in gold, hurt commodity prices overall (excluding oil), and battered share prices in resource economies. Emerging resource-based economies have also been hit by the mysterious malaise in China. Worried by the gyrations in currencies and commodities, investors appear to be funneling funds back into mature economies. But investors are too fearful to put money in bonds. Perhaps as a last resort, mature economy equity markets are relatively outperforming.
The Economy, Rates, and Earnings
The final 1Q13 GDP reading pushed the estimated growth rate down to 1.8% from a preliminary 2.4% number and an advance 2.5% reading. In a bit of "bad is good" reasoning, stocks rallied on the final revision in 1Q13 GDP to 1.8%, from a preliminary 2.4%, because the weakening GDP trend appeared to extend the life of quantitative easing. A few weeks later, however, stocks rallied on "good is good" news when the U.S. labor force added 195,000 workers in the June nonfarm payrolls report. This may signal that the stock market is getting used to the "new normal" of higher bond yields, including the 10-year yield at a two-year high.
Despite the reduction in final 1Q13 GDP, the underlying trend in consumer spending remains solid. Real personal consumption expenditures rose 2.6% in 1Q13; while below the 3.4% growth rate reported the preliminary reading, that is within our 2.5%-3.0% target range and up from 1.8% in 4Q12. Spending on durable goods overall was up 7.6%. Non-residential fixed investment edged up less than a point in 1Q13, after surging 12% in 4Q12. Some of this sharp step-down relates to accelerated investments made ahead of the fiscal cliff. Most of feared tax hikes that prompted that accelerated activity did not materialize. Equipment and software rose 4.1%.
Government remains a drag on GDP, with federal and defense spending down 8% and 12% respectively and state and local down in low single digits. Given the final 1Q13 GDP reading, we have edged down our full year 2013 GDP outlook to 2.6% from a prior 2.7%. We continue to forecast 3% GDP growth for 2014. But the economy will likely require a positive growth contribution from the government sector to reach 3% full-year GDP growth for 2014.
For a third consecutive month, investors have been confronted with a significant widening out in yields overall. The silver lining is the ongoing steepening in the yield curve, a pattern normally consistent with expanding economic activity.
Despite the significant upheaval since late April, we are not ready to call an end to the turmoil. Examination of ICI fund flows data shows the accelerating exit out of bond funds turning into a full-fledged panic, as bond fund outflows topped $28 billion in the first week of July. We expect the flow out of bond funds to remain at elevated levels across the remainder of 2013, and perhaps for as long as it takes for the Fed to set a new level of bond purchases.
In the mid 2.7% range, the 10-year yield has reached levels not seen since August 2011. The level of Treasury yields has broadly pushed past our 6-month targets, causing us to raise those targets in every asset class except the 3-month bill. The 2-year to 10-year spread is now 235 basis points, compared with 126 basis points a year earlier. On the upside, the widening two-to-10 spread has steepened the yield curve, which is consistent with expectations for additional economic expansion going forward. As summer winds along, the markets move closer to the day in which the Federal Reserve begins to actually taper its bond purchases. So one month from now, we could be standing here talking about even worse panic in the bond market.
With Alcoa (AA) having its report and earnings season getting underway, Argus Chief Investment Strategist Peter Canelo is looking for mid-single-digit year over year growth in S&P 500 earnings from continuing operations for the second quarter of 2013. Peter is higher than the Street; Bloomberg shows expectations for 1.8% growth, which is about half the forecast of one month ago.
The Street has persistently underestimated EPS growth rates all through this bull market. Even in recent quarters, when some earnings exhaustion might be expected given the age of bull market, EPS has continued to surprise on the upside.
Given the caution around the election and fiscal cliff in 2012, which caused a slowdown in domestic activity, we expect comparisons to get easier in 2H13. On average, our EPS growth expectations for the third and fourth quarters are in the low teens. Thus, we anticipate steadily accelerating annual EPS growth across the back half of 2013.
We then look for a reverse-mirror pattern of declining annual growth against tough comparisons across the four quarters of 2014. Overall, we have made no changes this past month in our forecast S&P 500 earnings from continuing operations for 2013 and 2014. Our 2013 forecast remains $110.80, and our 2014 estimate is $121.50. For both 2013 and 2014, we are modeling high single digit growth.
Global Asset Markets
A month ago, we were reporting that overall U.S. equity market had improved by several hundred basis points from the prior month. Then Fed Chairman Ben Bernanke held his infamous press conference in which he first put a potential time-line on the "tapering" of quantitative easing. Stocks were initially staggered by the news, with the S&P 500 at one point falling 7% from its 5/21/13 peak. While the bond market continues to head lower, however, the various equity indexes have clawed back. The Russell 2000 has the distinction of having improved from a month ago, despite the Fed's taper talk. Most other indexes have backed down about 1% since the press conference, for a net month over month decline of 0.8%. Compared with a month ago, the DJIA is relatively outperforming, as are value stocks in general. Those two categories are also the leaders in 2013 year-to-date.
At the sector level, Healthcare, Consumer Discretionary and Financial Services lead the market, with all three sectors up 21.3%-22.5% year to date. The rotation away from high-yield and defensive sectors continues. Chief Investment Strategist Peter Canelo points out that since the 1Q13 reporting period ended in mid-February, 80% of the leading groups have come from just two sectors, Consumer Discretionary and Financial Services. The winning groups, many of which are sensitive to the automotive boom and housing revival, tend to be domestic in nature and are characterized by dividend growth rather than high yield.
Redistribution of sector weights continues to favor healthcare, which has moved to a best-ever 12.7% weighting within the S&P 500 from 11.9% a year ago. Consumer discretionary is up 140 bps year over year. Financial services has increased its relative market weight by 230 bps in the past year, and at 16.7% is closing the gap with Technology. Falling 200 bps year over year to a 17.9% weighting, Technology continues to fade.
At the same time, income-oriented or defensive areas, including utilities, telecom services, and staples, are now losing relative market weight on a year-over-year basis. Utilities and Telecom Services both lost 40 basis points of market weight in the past year, with Utilities falling to a 3.3% weight and Telecom to 2.8%. Consumer Staples is down to a 10.4% weighting, from 11.3% a year earlier.
Two sectors with mid-teens performances, Staples and Industrial, are going in opposite directions. Compared with a month ago, staples are down about 200 basis points, though they are still ahead year over year thanks to first-half strength. Compared with a month ago, Industrials are up by about 1%, and the sector is up nearly 10% year over year.
The decline in Technology since last month is actually steeper than the average 1.4% decline for the two income sectors of utilities and telecom services. Materials are really struggling with dollar strength wrought by signs of economic recovery and the anticipated end of QE. The plunge in gold is another negative for Materials, which are down 4% year over year and down 2% month over month.
The U.S. Federal Reserve is not the only country considering an end to the excessively easy monetary policy known as quantitative easing. Most nations that participated in QE are now planning or have articulated a plan to wind down their programs. That is causing currency thunderstorms that are further impacting the commodity-based economies, including the two BRIC nations of Brazil (down a withering 27% YTD) and Russia (down 12%). At the same time, China's mysterious malaise has caused that nation's equity market (down 13%) to double its loss from a month ago. At the other end of the spectrum is Japan, up nearly 40% year to date with its unrepentant QE policy. Other mature economies, such as the U.S. and U.K., are up in low double digits. In something of a disappointment, the Euro Zone has given away the bulk of the 7% gain it was reporting a month ago and is now up less than 2% YTD.
Dollar strength may not have been a totally unanticipated outcome of the wind-down in QE. But, in concert with the softening in China, it has played havoc with emerging market returns. Forced by asset-price collapses to park their money elsewhere, exiting investors from the fixed-income and emerging-economy markets are helping the U.S. equity market conserve gains during turbulent times.