Harlan Levy: How fragile is the U.S. economy, in light of mixed August data - including weaker consumer confidence and retail numbers and expectations, but better jobs news with the lowest initial jobless claims since 2007?
Stuart Freeman: It is true that the consumer took a breather in July, but it may have to do with some concern about refinancig homes and maybe the heat in July. I wouldn't say that's going to be a trend. In general, confidence has been moving up, and you look at the initial claims numbers, and they're the best we've seen in about six years.
If you look at the confidence of homebuilders, that's risen to the highest level since 2005. And the building starts were up, mostly multi-family homes, and that's positive. We're starting to see builders adding workers. It's a slow climb, but we are seeing a climb.
When you look at the declining initial jobless claims, which are a leading economic indicator, somewhat better job numbers, and a better unemployment rate, those are all pretty significant factors, so it appears more likely that we do have continuing growth.
H.L.: So what do you see for stocks in the second half of the year?
S.F.: We've had a move in the S&P 500 to over 1,700 this year, and it was very broad, as far as the number of stocks that were up. Part of the reason we had such a strong first half was because last year there remained a high level of uncertainty with respect to Europe, the noise surrounding the presidential election, and going into the end of the year with fiscal cliff concerns. So we went into this year leaving a high level of uncertainty behind, and investors felt more comfortable taking more risks. To a degree, part of the significant move was stolen from last year and part of it was from this year.
Previously, our thoughts were that the first half of the year would be strong and the last half would be a more volatile period. And that's what we're seeing. You're moving into the part of the year when investors are waiting for a pullback from the first part of the year. With more uncertainty and possibly the Fed moderating its asset purchase policy in the next meeting because of continuing growth in the economy, investors are feeling that uncertainty. The Fed's objective is to take away some liquidity as the economy does better, so we don't end up with an inflation rate we don't want. But it shouldn't be too much of a surprise that we see some skittishness and profit-taking in the market and then the resulting increase in the 10-year interest rate.
However, we don't think we'll have a significant pullback in valuations. We think the period of volatility and some pullback is just a pause and that we're seasonally in the part of the year when the market is not the strongest, now through mid-October.
H.L.: What do you predict for the economy and stocks next year?
S.F.: We think the economy is moving ahead with more growth next year. It appears that Europe is slowly pulling out of recession, which should be good for larger multi-national company earnings comps. The emerging nations' fundamentals, like in China, may take a little longer than expected for the growth rate to stabilize and confidence to return.
What we'll end up seeing is an economy that continues to move ahead. We're still in a cyclical bull market.
Our target for the end of the year for the S&P 500 is in the 1,650 to 1,700 range, although we certainly could fall below that in the short run. Our preliminary target for the end of 2014 is 1,850 to 1,900. We'll see Europe do better. We'll start to see signs that emerging markets will do better. Our expectations for earnings is modest, about 5 percent earnings growth next year, but as confidence comes back we'll see some modest earnings growth and a little bit of Gross Domestic Product expansion.
H.L.: Do you think the move up in interest rates will kill the recovery?
S.F.: No. Certainly, as rates go up and mortgage rates go up it will slow refinances, but as the economy continues to grow you'll probably start to see some more mortgage-lending growth from the banking sector -- banks getting more aggressive with mortgage originations as the cycle moves ahead. So housing will slowly do better, as it has already. Building permits will continue to pick up, although it's not going to occur at a rapid pace.
H.L.: Are interest rate increases, especially the jump in the benchmark 10-year note, just a knee-jerk reaction to fears that the Federal Reserve will soon lessen its $85 billion-per-month purchases of Treasury and mortgage-backed securities?
S.F.: I don't know if it's knee-jerk. We're not seeing much inflation, but we have had a rapid increase in the 10-year Treasury rate, and it's possible that during this period of uncertainty with slow growth we could get a short-term rally in Treasurys before the 10-year continues to go up through next year.
We think it will be higher next year, but it could come down before that in the short-term. We are in a period when long-term interest rates will move moderately higher on a multi-year basis.
H.L.: Do you think the move up in interest rates will kill the recovery?
S.F.: No. Certainly, as rates go up and mortgage rates go up it will slow refinances, but as the economy continues to grow you'll probably start to see some more mortgage-lending growth from the banking sector, banks getting more aggressive with mortgage originations as the cycle moves ahead. So housing will slowly do better, as it has already. Building permits will continue to pick up, although it's not going to occur at a rapid pace.
Next year's GDP growth next year may be 2 percent, relatively slow, but moving forward. Meanwhile, the deleveraging is still going on in the economy.
H.L.: Now that earnings season is almost over, what's your analysis of the results?
S.F.: We've seen what we need to see. Overall, it's been a slow quarter. Revenues are up year-over-year 2.7 percent, and not counting financials, they were up 1.8 percent in the S&P, and 67 percent came in better than expected, although that was from day-before reporting. Market-capitalization-weighted earnings for the S&P went up 1.7 percent overall, and that's slow. The non-financial sectors were down if you take the financials out.
Some of the weaker sectors by revenue were energy, off 4.1 percent year-over-year, and materials down 1.1 percent. But when energy prices come down that's a positive for many other sectors of the economy.
Stronger sectors were utilities, up 9.9 percent year-over-year, the financials up 8.1, and consumer discretionaries up 6.9, but going forward the more cyclical areas will be the areas to accumulate for continued growth next year.
H.L.: Egypt and Syria, not to mention Afghanistan, are boiling over. How concerned are you, and how much might they affect the U.S. recovery?
S.F.: To the extent that it affects the movement of oil, it's another uncertainty, but I don't think those problems will have a material impact.
H.L.: Back in Washington, Republicans keep saying that the deficit is rising when it's actually plummeting, and we face a possible government shutdown over the fall deadline to keep funding government operations and the need to raise the debt ceiling. How much is this knocking back the economy's recovery?
S.F.: The budget issues will continue to be a question mark and will probably result in a slower economy over a longer period of time. We're already seeing some tax increases, and they're probably having some impact on the growth rate.
H.L.: Has the deadlock in Congress and the implacable divide between Republicans and Democrats caused by both parties not compromising make it hopeless to govern?
S.F.: I wouldn't say impossible. It would be nice to see some movement on the budget. Without cooperation, we're sitting with a budget issue that's not taking care of itself, and over the longer haul, it has to be addressed although I don't think it will crater bonds in the near term. But over a much longer term, these budget issues need to be addressed.
To move forward in Congress you have to all the bodies of government working together. Usually if Congress can't get it done, the economy does, but in this case we really do need Congress to make decisions.
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