We are about to go off the grid for a few weeks. First, however, we will sum up our thinking on the state of the markets after a roughly 20% gain in the year's first seven months.
For the sake of brevity, we offer our thinking in bullet points. For the sake of concision, we divide our thoughts into four interlinked categories: The Bull Market since 2009; The Global Economy; The Investing Environment; and Outlook for U.S. Equity Markets.
We will then offer more detailed views on the economy, domestic and international markets.
The Bull Market since 2009
· In the four-year bull market, stock market returns have been aligned with earnings growth, with both the S&P 500 earnings from continuing operations and the S&P 500 itself rising over 100%.
· Throughout this period, earnings have grown at 2-to-3-times the pace of U.S. GPD growth, based on:
o productivity enhancements and flexibility on the P&L,
o emerging economy expansion, and
o lower blended tax rates, low-cost debt service, and share repurchases.
· Based on acceleration in the global economy, U.S. corporate earnings should continue to grow, further supporting a rising U.S. stock market.
· We regard U.S. equities as an attractively valued asset class, based on our:
o earnings yield model and normalized earnings, and
o forecast for ongoing earnings growth.
The Global Economy
· The United States remains in a low-grade but persistent recovery.
· Economic leadership in the U.S. has handed off from the industrial sector, reliant on weak dollar and emerging-economy strength, to the consumer economy, driven by housing and automotive and largely indifferent to the strong dollar trend.
· Europe, absent as an end market for U.S. multinationals in recent years, is showing signs of stabilization.
· China appears to be in re-set mode, but should continue to deliver 7% growth while stimulating activity in the emerging world.
The Investing Environment
· The economic dislocations wrought by recession have contributed to heightened geo-political instability in nations such as Syria, Egypt, North Korea, and others.
· Since the great recession, the investing environment has been negatively impacted by policy prescriptions as governments attempt to "fix" the global economy.
· Unpredictable deployment of policy remedies, such as various quantitative easing schemes around the world, has interfered with behavior of capital markets.
· That has led to tumultuous and unstable asset-market leadership and to unpredictable sector leadership within the equity markets.
· We also see currency movements and policy events contributing to the relative attractiveness of U.S. equities in relation to other asset classes.
o Dollar strength pushes down commodity prices and hurts emerging and resource economies.
o The planned tapering of U.S. (and other nation) quantitative easing is potentially triggering a major rotation out of fixed income assets.
Outlook for U.S. Equity Markets
· We expect the investing environment to remain unsettled and unpredictable, based on:
o ongoing policy implementations,
o currency fluctuations,
o uneven rotation out of global fixed-income amid rising rates, and
o continued geo-political instability.
· This heightens the need for broad diversification across equity sectors:
o Within equities, we would look for uncorrelated return streams (stock charts that are not identical and/or overlapping).
o And we would favor counter-market rebalancing (buy low, sell high), which tends to do well in unpredictable markets featuring frequent sector leadership changes.
· We see the U.S. as a bastion of relative strength in an uncertain world. And we anticipate additional earnings growth to support further equity market appreciation.
· On that basis, we believe U.S. equities are well-positioned in this unsettled environment.
Now, on to our discussion of the U.S. GDP, interest rates, and equity market performance.
The Economy and Interest Rates
The second-quarter 2013 GDP report contained multiple surprises, coming in well above Street expectations but also including a substantial downward revision in 1Q13 GDP. The advance report on 2Q13 GDP showed a gain of 1.7%, better than the consensus forecast around 1.0%. But 1Q13 GDP growth was revised down to 1.1%. The lower level of 1Q13 at least partly reflects its inclusion in a comprehensive, multi-decade revision dating back to 1929.
In the second quarter, growth was driven by personal consumption expenditures, non-residential fixed investment, and exports; we also saw signs of stabilization in government. Real personal consumption expenditures increased 1.8% in 2Q, down from 2.3% in 1Q13 partly because fuel was less costly in 2Q. Within the consumer space, 6.5% growth in spending on durable goods improved relative to 1Q13. Non-residential fixed investment, a proxy for business capital spending, rose 4.6% in 2Q after declining by a revised 4.6% in 1Q13. Exports accelerated strongly in 2Q relative to 1Q. And the drag from government lessened, with state and local actually contributing (fractionally) to 2Q growth.
We think these positives set the tone for a stronger second half. Given the sub-2% GDP readings in the first half, however, we have reduced our full year 2013 GDP outlook to 2.2%, from a prior 2.6%. We continue to forecast 3% GDP growth for 2014. The economy will require a positive contribution from the government sector, in addition to continuing consumer and business spending growth, to reach 3% full-year GDP growth for 2014.
We think it is safe to say that there is a "new normal" on the yield curve, with rates across the curve significantly higher than they were in the spring. At the same time, the yield curve seems to have stabilized approximately at current levels over the past month or two. The flood of money out of bond funds reported by ICI has moderated.
The tumult began after the Fed acknowledged that it would begin tapering its quantitative easing spending. But the Fed then qualified its intent by stating that any reduction in bond purchases was subject to revision based on overall trends in the economy. Given this double-talk, we may see market rates of interest and Treasury yields remain stable through summer's end and possibly longer.
Currently, the yield on the benchmark 10-year Treasury bond is now 2.65%, or 10 ticks below where it was a month ago. The 30-year is approximately where it was a month ago. Shorter maturities, including the 2- and 5-year notes, have moved down more dramatically relative to a month ago. The 5-year, for instance, has slipped to 1.39 from 1.54 a month ago.
Investors appear to be betting that the Fed may move the beginning of tapering out from September to later in the fall or early winter. Argus continues to believe that tapering will begin in September. At that point, we will see if the recently somewhat stable yield curve begins moving up once again.
We have reduced our 2013 earnings outlook slightly, on concerns about the strong dollar, yen movements, and commodity prices. Final 1Q13 EPS outpaced expectations and grew in mid single digits; ditto for 2Q13, which also grew in mid-singles. For both quarters, the consensus - blindly following conservative guidance - was anticipating low-single-digit to no growth. We have, however, shaved our expectations for the back half of 2013. The strong dollar is likely to hurt earnings of U.S. exporters and multinationals. We estimate that if the dollar remains at current levels against the trade-weighted currency index, earnings will be hurt by 2%-3% in the next two quarters.
Another slight negative in the outlook is lower industrial commodity prices, which means lower industrial profits. Finally, the plunge in the yen has impacted growth in China and is causing fits in South Korea; these are two of our more important trading partners. We think the strong dollar-weak yen combination could particularly crimp U.S. profits in Southeast Asia.
That said, our lower forecast for 2013 still implies 8% EPS growth in S&P earnings from continuing operations. We then look for 10.5% growth in 2014 earnings. Stock market performance has been tightly aligned with earnings growth, and we think continued EPS growth supports further stock-market appreciation.
Sectors & Markets
The U.S. stock market took a body blow in June when Fed Chairman Bernanke first spelled out a potential time line for tapering late. But there is no question that stocks have absorbed the blow and moved on, with several major indexes including the S&P 500 posting new all-time highs in July and August. In the months since the equity market adjusted to the post-tapering world, we have seen strong relative outperformance in traditional risk-on areas such as Growth, meaning the Wilshire Large Growth index, and in small to mid-cap names, meaning the Russell 2000. That said, the market is showing impressive breadth in that nearly every major domestic index has delivered year-to-date total return of 20% or more. Bonds of course are lagging. But in the at-least-you-stopped-hitting-me-on-the-head-with-a-hammer department, the negative 2.5% return in the Lehman bond index is approximately level with where it was one month ago.
In terms of sector performance, the rich continue to get richer. Fueled by the furious rally from mid-July through early August, the year's leading sector of Healthcare added 840 basis points to its annual gain in just the past month; Healthcare is up one tick shy of 30% for 2013 with nearly five months left in the year. Consumer Discretionary, currently in the second spot year to date, tacked on 630 basis points to bring its full-year total return to 28.9%. Industrials added 720 bps last month, bringing its year-to-date total return to 22.2%.
Earlier we noted that the runaway rise in yields had slowed and that yields even showed signs of stabilization. Similarly, the break-neck rotation out of high-yield and defensive sectors has also slowed and shows signs of stabilizing.
Five sectors are lagging the broad market year to date: Telecom Services, Technology, Energy, Utilities, and Materials. While the rich get richer, some of this year's lagging sectors also performed strongly last month. Materials added 620 basis points last month, bringing its full-year total return to 10%. With the best-performing sectors looking pricey, investors appear to be scouring the laggards for value. This could help drive relative outperformance for the bottom five sectors across the second half.
In terms of setting sector tilts, "strong dollar" currently looks like a bigger factor than "the great rotation" (out of bonds). Sectors with heavy international exposure, such as technology, appear to be faring worst. On a year-over year basis, technology has backed off by 200 basis points, to a 17.7% weighting in the S&P 500. This is the lowest weighting in technology since the recession. Interestingly, investors are about equally divided as to whether the technology weighting is too high or too low, as the Cloud brings massive disruption to the tech space.
The sector that has gained the most in the past year is financial services, up 250 bps year over year to 16.7%; that is the financial sector's highest reading since the recession. Consumer discretionary has gained 150 bps year-over-year, but has lately backed off. Income-sensitive sectors such as Utilities and Telecom Services have each given back sharply in the past year, with telecom shedding 80 basis points to 2.6% and Utilities down 50 bps to 3.3%.
Most of the world's equity markets are doing okay to very okay in the year to date. For the first time in the market recovery that began in spring 2009, the DJ World index is above 10%; in fact it was at 11.7% when we took this market snapshot. Japan continues to lead the way with its nearly 40% year to date gain. There is something artificial in the Japanese advance, however, in that the gain reflects radical financial engineering from the Bank of Japan. The gain also reflects a bounce after decades of terrible performance in the Nikkei 225. Other mature economy markets are also rallying, led by the U.S. and U.K. In a highly encouraging sign, the Euro Zone weighted market index is up just less than 10% year to date. Bringing up the rear are the resource economies, continuing to suffer from weak dollar. The worst of the bunch remain the BRICs, which average a 10% annual decline. We expect China to get its groove back. But until it does, look for BRIC to remain a lagging equity area.