Risk-On Returning? Monthly Survey Of The Economy, Interest Rates And Markets

by: Jim Kelleher


In the scant few weeks since 5/20/14, the S&P 500 has advanced 4.5% - representing the bulk of the year’s 5.9% capital appreciation.

Two things helping the market across have been the absence of big sell-off days and the predominance of up days, even if they are mainly “grind higher" days.

Overseas, in this very short span, leadership has shifted from mature economy markets to the BRICs and emerging markets.

The S&P 500 struggled to move higher in the first four months of the year, contending with the surprising drop in interest rates, Mr. Putin's Ukrainian adventure and harsh weather that froze out consumer spending on houses, restaurants and cars. The S&P 500, which began the year at 1,832, had gotten no further than 1,872 - a scant 2.1% gain - by May 20. In the scant few weeks since, the S&P 500 has advanced 4.5% - representing the bulk of the year's 5.9% capital appreciation as of 6/18/14.

Two things helping the market across this surprising rally leg have been the absence of big selloff days and the predominance of up days, even if they are mainly "grind higher" days rather than big honking rally sessions. On a sector basis, leadership has shifted away from defensive and income sectors such as utilizes and telecom services and toward economy-sensitive sectors and inflation-sensitive sectors such as technology, discretionary and materials.

Overseas, in this very short span leadership has shifted from mature economy markets to the BRICs and emerging markets. The surprising Treasury rally across January through early May appears to have faltered (although Yellen's FOMC comments may have given Treasuries new life). If that move is spent, we would expect continued reassertion of leadership in riskier, smaller-cap and emerging economy assets.

GDP, Rates and Earnings

Like everyone on the Street, we've had to dial down our 2014 GDP expectations based on the weaker-than-expected first-quarter performance. After the advance report of a 0.1% decline, investors were caught up short by the preliminary report of a 1.0% decline in 1Q14 GDP growth. There were a few positives in this report, including 3.1% growth in personal consumption expenditures - up from 2.4% for all of 2013. Intellectual property products spending grew, and federal government spending (particularly non-defense spending) was positive after six straight quarters of decline.

On the downside, gross private domestic investment - which captures the business economy as well as housing - declined in the double-digits. Within that category, spending on structures was down 7.5%. Another big negative was the change in private inventories, which declined by $63 billion from 4Q13. In the final two quarters of 2013, stockpiles were growing at a $100-billion-plus pace.

In essence, the negative GDP in 1Q14 has dragged down our full-year 2014 GDP growth forecast to 2.0% from an earlier 2.6%. But we do see the potential for recovery in inventories and catch-up spending in housing to drive GDP well above consensus for 2Q14. We are modeling modest growth in spending on structures. The housing data from April on (and even March) has been universally good. It is harder to get a handle on what inventories will be at corporations and at distribution. Currently, we are modeling virtually no growth in stockpiles for 2Q14 and only modest growth in the second half. We expect the consumer to keep chugging along at a 3% growth pace this year.

The slow start to 2014 could impact economic momentum heading into 2015. We are now modeling 2.8% growth for 2015, down from earlier expectations around 3.0%. Once again, the outlook is full of wild cards including government spending, net exports, consumer spending, housing and capital spending. Generally, we see the economy recovering from the hard winter, while acknowledging that we did not expect winter's impacts to be so harsh.

It's a natural segue from the disappointing GDP performance to the current level of bond yields. Plainly, rates in general and long-yields in particular are well below where economists expected them to be when they were putting their models together in autumn 2013. Those seeking to explain this wide miss on rates point first to the economy, where the 1Q14 GDP drop was strong enough to seem more than weather-induced. Investors also point to slowing growth in the emerging economies, geopolitical risk, overvaluation in stocks after the 2013 rally year, and Fed Speak.

Weakness in Asia's emerging economies was largely the result of Japan's deliberate effort to tank the yen in 2013 in an effort to improve its trade competitiveness. We believe this effect has largely washed through Asian emerging economies. Other troubled emerging nations, from Brazil to Turkey, show signs of economic stabilization. The geopolitical risks from Russia's Ukrainian incursion now appear to be discounted in the markets.

Fed Chairperson Janet Yellen likely was too precise in providing a timetable for more restrictive policy, then over-corrected by severing Fed policy moves from earlier policy targets such as a 6.5% unemployment target or 2.0% annualized inflation. This may have led some bond investors to conclude that easy policy is now perpetual, when we would argue that the Fed chair never meant to make that case.

One cause of low yields may be as simple as scarcity: the federal government is just not borrowing as much this year as it has done in recent years. The federal deficit, which ran in the $1.1-$1.4 trillion range from 2009 through 2012, shrank to $680 billion in 2013 and may not reach $500 billion in 2014. Because the Treasury is shrinking its debt issuance faster than the Fed is tapering, so far in 2014 the Fed has purchased an even higher percentage of total Treasury issuance than in did in prior years.

That could change in the second half, as the tapering program winds down and QE ends. The recent modest rise in rates may be a precursor to a sharper rise later in the year. We are maintaining our view that long yields will rise sustainably to the 2.75% or higher level this year, although 3.25% at the high end now seems like a stretch.

Our final assessment of 1Q14 growth in S&P 500 earnings came in around 5%, much higher than the 1% consensus forecast compiled late last year. While the bond market may be priced for ongoing weakness in the global economy, actual data since the first quarter has been strong, supporting additional growth going forward. In the U.S., durable goods (excluding the volatile transportation sector) were up 8% annually on a three-month rolling basis as of the end of April. Purchasing managers indexes worldwide are in a rising trend - PMIs are strongest in the developed world, led by UK and U.S.

The long-quiescent emerging world is showing signs of recovery, led by Australia - regarded as a mirror on China. Rising commodity prices reflect mature economy strength, but may also suggest improving Chinese demand not seen since last decade. We are reiterating our 2013 EPS forecast of $120 for 2014.

Earlier this year, Argus Chief Investment Strategist Peter Canelo introduced his preliminary EPS forecast for 2015. Off the estimated 2014 base, Peter is modeling 6% growth in continuing operations earnings, to $127.25, for 2015, without yet providing a quarter by quarter breakout. Our 2015 below-consensus estimate reflects our conservatism, although one past concern may be melting away. Initially we assumed that the Fed might begin to raise interest rates in mid-2015, which would increase the cost of financing required for major projects and business deals. Given the state of the Treasury market, a mid-2015 rate hike looks less likely now. We will likely remain conservative in our 2015 EPS estimate, while watching how actual 2014 earnings play out across the year.

Sector, Domestic and Foreign Market Performance

There has been a notable acceleration in domestic equity index performance since late May, and specifically since 5/21/14. The S&P 500, which began the year at 1,832, had gotten no further than 1,872 - a scant 2.1% gain - by May 20. In the few weeks since, the S&P 500 has advanced 4.1% - representing the bulk of the year's 5.5% capital appreciation. Most of the other indexes have accelerated upward as well, although small caps and risk-on indexes had a big hole to dig out of and are barely break-even YTD.

The best-performing equity index is the S&P 500, which had a year to date total return of 6.3% as of last week's market close. Right behind is the value category, as Wilshire Large Cap Value is 6.1%. Nasdaq and DJIA are both in the 3%-4 range, joined by the Lehman US Aggregate Bond index. Wilshire Large-Cap Growth and the Russell 2000 have pulled up from negative territory, but are up less than 1% year to date.

Assuming long yields continue their gradual chug higher off their lows, we could see more money swing into these two riskier asset classes. The later we get in the year, the more the leadership will become entrenched and in fact build on their advantages. For now, though, investing styles are still in flux.

The S&P 500 gained about 410 basis points of total return between early May and early June. The strongest sector in the past month has been Information Technology, up by a startling 610 basis points in the past month alone. Other risk-on sectors that have moved up in the past month include Consumer Discretionary, Industrials and Materials. Sectors that have underperformed the market's 4.1% gain in the past month include Telecom, Staples and Utilities, the defensive and income-oriented sectors. Energy has also lagged slightly in the past month.

A year ago at this time, the S&P 500 was up 15% year to date. Financials and Discretionary have taken the biggest steps backward; materials and technology are about where they were one year ago. Utilities have done the best compared to where they were one year ago, where every yield-sensitive sector was running scared amid the first talk of "tapering."

The sharp decline in bond yields over the first few months of 2014 had a galvanizing effect on defensive stock categories. These include Utilities, along with the defensive consumer staples sector. The leadership change in the second quarter, however, is impacting sector distribution. The most notable short-term change has been in Information Technology, now comprising 18.8% of S&P 500 sector weight. That's up 30 basis points in just the past month and 80 bps in the past year. Recent outperformance in the sector reflects strong quarterly results for some late reporters, such as Cisco and H-P; a burst of M&A activity; and Apple's 7-for-1 stock split.

The two defensive categories of Utilities and Consumer Staples, meanwhile, gave back the most last month. Staples and Utilities are now both significantly smaller year over year, whereas healthcare is a slightly larger percentage of S&P 500 sector weights.

When it comes to market performance of defensive sectors, we can study the operating fundamentals in Utilities, based on KW hours growth, and in Consumer Staples, based on lower feedstock costs and consumer recovery. But the clear driver appears to be interest rates. Defensive sectors advanced when long bond yields moved from 3.0% to 2.4%, and have retreated during the recent rise past 2.6%. Unless long yields reverse once again, we would expect investors to continue to favor inflation beneficiaries and economy-sensitive sectors over defensive sectors.

Generally, global markets are in better shape today than they were last month. The 11 indexes in our global survey were down about 1% in aggregate early in May. As of early June, this group is up an average 3.8%. Notable leadership acceleration in the past month is led by India, which is to 2014 what Japan was to 2013. India now leads with a 21% gain year to date, putting it 1,100 basis points ahead of second-place Canada.

India's strong showing is helping BRICs overall, which on average are up 5.4% year to date after being down 1% one month ago. Granted most of the momentum is in India, but Russia has bounced back strongly after being down about 20% two months ago. And Brazil has now swung to positive, ending a more than one-year period of being in the red.

While leadership remains with the mature economies, most of the recent momentum is in the emerging world and in resource economies including Canada, Brazil and Russia.

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