Heading into 2014, even perma-bears were growling bullish forecasts. That always makes us nervous; when everyone agrees something is happening in the market, count on the opposite to happen. The U.S. market has rallied back from the late-January lows. The stock market has had a rough opening month and a half, but uncertainty has now displaced bearish conviction. Stocks suffered their worst single-session loss since June 2013 and their best two-day rally since October - all in the same week..
In our view, emerging economies remain the riskiest factor in the equation. As of 2/11/14, stock markets in the BRIC nations were down an average 7.1% year-to-date. Other growth economies are down, including a 5.5% pullback for our significant trading partner Mexico. China's recent trade balance report chased away some of the gloom, though the data may have been distorted by the Chinese New Year.
January selling may have been the buyable dip this bull market needed to recharge its batteries. Or it could serve as precursor to a nastier decline, perhaps into bear territory. While is hard to know whether bulls or bears are in charge in the stock market, the economic and earnings backdrop remains positive.
Ironies abound in this period. The first taper was a toe in the water, but the second taper shows the Fed taking the plunge. In addition to reducing Treasury demand by shaving an additional $10 billion off its monthly bond purchases, the second taper signaled that the Fed believes the economy is accelerating. Yet the long bond has strengthened, not weakened; and the 10-year yield has shed 40 bps since year-end 2013. Similarly, the latest emerging-markets sell-off began about a day after the head of the IMF raised her agency's outlook for global GDP growth.
The Fed's aggressively easy money policies of recent years spilled into the global economy. Many emerging nations that became dependent on artificially suppressed borrowing rates are now struggling. Prospects for higher interest rates in the United States draw capital away from nations now seen as riskier investments.
Argus Chief Investment Strategist Peter Canelo believes the correction in emerging markets is a currency-driven correction. Peter reports that nations with the biggest stock-market declines are also the nations with the steepest currency declines. The currency correction in emerging economies was spurred initially by Japan's QE-based effort to devalue the yen. Prime Minister Abe's policies to depress the yen and drive export growth have boosted the Japanese markets - at the expense of emerging markets in the region such as South Korea, Malaysia and Philippines and Indonesia. The launch of Japan's QE cycle dates back to the third quarter of 2012 and coincides with the U.S. Fed's launch of QE3. We think Japan has almost reached the end of its currency depreciation cycle. Stability in the yen would help emerging markets turn around later this year.
Although "emerging economies" have been targeted as the main problem, there are varying degrees of risk in the various nations. The two biggest problem nations at present are Argentina and Turkey. Beyond the shared pain from rising market rates of interest, both have their own local problems that are not tightly linked to other emerging nations. Argentina has weakened in part because of its exposure to commodities, but the trend has been accelerated by the government's response, including imposing capital and currency restrictions. Markets don't like that type of government activity. In Turkey, public sector corruption has caused investors to lose confidence.
Neither of these economies is a major trading partner with the U.S., so in that respect the U.S. economy is insulated from their turmoil. Four emerging economies - Mexico, China, South Korea, and Taiwan - comprise nearly 40% of U.S. overseas trade. Although South American currencies have tracked Argentina lower, currencies in Southeast Asia, along with the Mexican peso, have held up well in a positive for our trading outlook .
Argus President and Economist John Eade believes economic risks related to China are real. China alone accounts for about 21% of U.S. trade; interestingly, the other three BRICs (Brazil, India, and Russia) collectively account for about 6% of U.S. overseas trade. China's manufacturing indexes seem to fluctuate monthly around signals of expansion or contraction.
Even at its recently slower growth pace, China remains on track to surpass the U.S. and become the world's largest economy later this decade. But China is aiming for more than outright growth. On a per-capita basis, China is about one-fifth as wealthy as the United States. China seeks to close that gap and raise the standard of living for its population. Given the priorities of China's leadership, growth in per-capita-GDP supersedes absolute Chinese GDP growth, whether that number is 7.0% or 7.5%. And as long as per-capita GDP growth remains the priority, China will continue to represent a growth market for the U.S.
The U.S. economy, meanwhile, continues to represent a global bulwark, the poor January ISM manufacturing number notwithstanding. The U.S. economy delivered 3.2% growth in GDP during 4Q13. A few months ago, that would have seemed very strong; instead, investors focused on the 90 bps decline from 3Q13 GDP growth of 4.1%. We note that a significant component of 3Q13 GDP growth was inventory accumulation. The 4Q13 GDP number revealed healthy and broad-based trends in consumer spending and corporate investment.
Corporate earnings also appear sound. As of mid-February, the bulk of the S&P 500companies had reported calendar 4Q13 results. Reported earnings growth so far has averaged around 10%, in line with our expectations. Calendar 4Q13 sales growth has averaged 3.4%, and that is better than our 2%-3% forecast. Amid trading-partner currency weakness vs. the dollar, many U.S. companies are reporting "constant currency" sales growth that is running one to two percentage points higher than GAAP sales growth.
With the global economy appearing to strengthen, the U.S. economy leading, and corporate earnings accelerating, we are not amending our investment strategy. We regard recent weakness as a buying opportunity.
(John Eade, Argus President, and Jim Kelleher, CFA, Argus Director of Research)