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Although the sorry spectacle in Washington continues, the economy continues to grind higher in its uneven way. The consumer economy has been able to hold onto its momentum as measured by actual activity, even as sentiment weakens amid the budget deadlock and debt-ceiling impasse. Many longer-term sentiment indicators, however, appear to be looking beyond the current deadlock. The NFIB optimism index and the ISM-Services index are two data series with month-over-month declines in the headline number, but a positive trend in the expectations component of the survey.

The Economy, Interest Rates and Earnings

The final revision to 2Q13 GDP growth reiterated the 2.5% growth rate reported in the preliminary report. Most of the data points in the final report echoed the preliminary report. Personal consumption expenditures grew 1.8% in 2Q13. While total consumer spending was below the desired 2.5%-3.0% range, investors were cheered by the 6.2% growth in durable goods. Over the past four quarters, durable spending growth has averaged 7.7%. We do see risks that in the current spending splurge on homes and cars, consumer spending on incidentals is weakening. Spending on IT increased just 3.3%, down from nearly 12% growth in 4Q12 and mid-single-digit growth in 1Q13. IT growth typically accelerates in the calendar second half, and the year-earlier comparison will be particularly easy in the recently concluded third quarter.

In 2Q13, government spending declined 1.6% after declining in high single to low double digits in the preceding two quarters. We had been looking for a more stable government contribution to GDP. Of course, the bipartisan battle over the federal budget and the debt ceiling means the government is spending practically nothing at present. Much worse are the collateral effects on the economy, reflecting the temporary absence of 800,000 paychecks supporting the private sector and sudden stoppage in government contract work. The budget battle can be resolved at any time, and we are assuming sanity will prevail and the two sides will reach agreement before the debt ceiling expires at mid-month. We had been expecting GDP growth to advance 2.8% in the 2013 second half. Depending on the timing of any agreement, we may need to adjust that outlook downward. For now, we continue to forecast 3% GDP growth for 2014. Assuming new spending cuts are part of any debt ceiling agreement, the economy may need to overcome a potentially negative contribution from the government sector to reach 3% full-year GDP growth for 2014.

The trend in Treasury yields has become enormously volatile. Looking at the benchmark 10-year rate, it moved from 1.63% in the beginning of May to 2.71% by mid-July, slipped briefly back to 2.5% in August, and raced to 2.98% early in September. The 10-year yield has moved in the 2.6%-2.7% range, twitching higher or lower on every rumor of settlement or breakdown in the talks. We expect changes in asset values to move in waves even with a general trend. We believe the uptrend in interest rates remains intact, but the latest retreat reminds us that the interest rate outlook and the bond market are subject both to economic indicators and to policy events. The yield on the two-year note has come off more than 10 basis points since early September, and the five-year has also weakened. The 30-year yield moved the least, however, signaling that investors expect no real and lasting damage from the current government shutdown.

Should the current impasse in Washington carry beyond mid-month October, we would expect to see real damage done to domestic economic growth in the fourth quarter. In theory, a debt default would prompt investors to demand higher coupons on federal debt. But a U.S. debt default would be so disruptive and frightening to many investors that their first instinct might be shelter in U.S. debt - which would have the opposite effect of sending bond prices higher and interest rates lower. That is roughly what happened after the near-default in July 2011: 10-year yields on average were lower in the second half of 2011 than in the first half. The main takeaway is that until the government resumes normal function, uncertainty will remain intense in the Treasury market.

As we head into the 3Q13 earnings season, our 2013 outlook for S&P 500 earnings from continuing operations is unchanged. But the government shutdown is contributing to uncertainty here as well. While 3Q13 earnings were not impacted by the October 1 shutdown, the fourth-quarter outlook is now in flux. The sad thing about the intransigence in Washington is that it threatens to disrupt what had been a positive overall trend in the global economy and in the domestic economy in particular. Although the shutdown deprived investors of September non-farm payrolls data, the ADP private payrolls report and the trend in unemployment claims support the outlook for continued monthly gains in the 160,000-200,000 range.

Since mid-September, we have seen continually strengthening data from the housing economy, ongoing strong automotive data and better-than-expected readings in Chicago PMI, the ISM manufacturing index, and personal income. The dollar has pulled back from recent highs, benefiting the earnings of exporters and multinationals. The one thing that is wavering, however, is consumer sentiment and confidence. Maybe the most telling data point is that Congress's approval rating has sunk to 14%. Our outlook for 2013 earnings from continuing operations is $111, and our 2014 S&P 500 earnings forecast is still $121.50. Assuming resolution of the budget and debt-ceiling issues by mid-October, we anticipate 5% EPS growth in 2013 and stronger 9.5% growth in 2014. If shutdown continues past mid-month, all bets are off.

Global and Domestic Markets And Sectors

After shedding about 320 basis points of year-to-date total return across August, the S&P 500 clawed back 140 basis points of its lost gains across September. On average the major U.S. indexes were up over 200 basis points as of mid-October from where they were at the beginning of September. Across mid through late September, stock prices were responding favorably to a range of positive economic data points. Within the increasingly volatile market, we detect some subtle shifts in leadership.

Compared with last month, growth stocks (Wilshire Growth) have outperformed value stocks (Wilshire Value); we have not been able to say that for about two years. Compared with last year, Value (up 27% YTD) is way ahead of growth (up 19% YTD). Over the past month, Russell 2000 (up 29% YTD) was the best performing major index. Relative outperformance in the Russell 2000 indicates that as the market heated up in September, investors were trolling for value among smaller, faster-growing and less-seasoned names. Russell 2000 has also shown the most relative improvement from where it was one year ago, when quality rather than growth led the market. Bond investors can draw some consolation that the year-to-date loss in the Lehman index was cut in half over the past month. Still, the index is down 2.3% YTD, and the trend in bond prices remains negative.

While not nearly as volatile as the bond market, the stock market has become increasingly turbulent since the first taper talk in April and May, and that is impacting relative sector performance. Following a strong start to the year for defensive names, momentum shifted to economy-sensitive sectors as the economic data improved. The Federal Reserve appeared spooked by the more than 100-basis-point rise in rates between May and July. The withdrawal of Larry Summers from Fed Chair consideration and the Bernanke Fed's unchanged policy in September both contributed to the sense that tapering would be delayed. The government shutdown has only strengthened that perception. Yet the increasing likelihood that tapering will be pushed out to mid-2014 or even beyond has not been sufficient to swing momentum back to defensive sectors.

The total-return sector leaders in 2013 are consumer discretionary and healthcare, which have swapped in and out of the top spot all year. Both sectors have delivered total return topping 29% in the year to date. Financials and Industrials are also up more than 25% year to date. Technology, Materials, Utilities and Telecom Services are all lagging the overall market in 2013, but all but Utilities are now showing double-digit total return for 2013.

Over the past month, stock-recovery performance has been led by economy-sensitive sectors including industrials, materials and technology, defensive and yield sectors such as staples, utilities, and telecom services have extended their lagging performance relative to the overall market. On a year-over-year basis, the sectors that have most meaningfully improved their relative performance include Industrials, Healthcare, Discretionary and Energy. The sectors faring worst compared to where they were at this time one year ago include Telecom Services (down over 2000 bps compared to where they were one year ago) and Technology.

In terms of relative weight within the S&P 500, several sectors are down from early September, including economy-sensitive areas such as financial services and information technology. Consumer staples and telecom services, two higher-yielding defensive sectors, have seen their weightings pull back in line with the growth sectors.

One area of accelerating strength has been the industrial sector, which has added 40 bps of sector weight month-over-month and 90 basis points year-over-year. In addition to encouraging demand trends data from Europe and Asia, the industrial sector is benefiting from recent dollar weakness. The consumer staples weighting in the S&P 500 continues to melt away, declining by 90 basis points in the past year, and we are not sure why. But it may be that consumers are so preoccupied - and potentially over-committed - with vehicle and home purchases that they are skimping on branded food and personal care.

From a global equity perspective, year-to-date market leadership remains in the mature-economy sector, led by Japan, the U.S., the U.K., and the Eurozone. But emerging economy markets are showing their best trends all year. BRIC nations in aggregate are now up 1.95% year to date, after being down 5% YTD one month ago. Compared with one month ago, we have seen an encouraging turnaround in Russia, followed by China and India. Resource economies such as Canada and Russia have improved over the past month, but still lag the mature-economy world leaders year-to-date and Brazil is still a mess, down 11% year to date. Compared with one year ago, Japan continues to show the most dramatic change in relative performance, rising 3000 bps from where it was positioned in October 2012. National markets that have lost the most ground since last year include India, Mexico and Brazil.

Conclusion

Washington must get its act together or the fourth-quarter economic growth will miss expectations. Resolution could come at any time, after which we'll immediately move on to the next thing and bury the memory of this sorry episode.

As radicals reshape both parties and as partisan positions harden, the normal functioning of Washington is increasingly constrained. We may avoid government shutdown this time. But the demise of compromise in Washington puts us on a seemingly inevitable path to debt default and the chaos that it entails.

(Jim Kelleher, CFA, Director of Research)

Source: Monthly Survey Of The Economy And Markets