U.S. Equity Strategist Sam Stovall: GDP Up 2.1% In '14; 3% In '15

by: Harlan Levy


2014: GDP up 2.1%. 2015: up 3% with good, not great global recovery.

Unemployment: Structural problems, U6 nearly 2x 6% jobless rate.

Interest rates up mid-2015, inflation up 1.9% in ’14, less than 2% in ’15.

Sam Stovall is U.S. equity strategist at S&P Capital IQ as well as the author of The Seven Rules of Wall Street and the column Stovall's Sector Watch.

Harlan Levy: How is the economy doing from the latest data, including existing home sales up and weekly unemployment claims down?

Sam Stovall: The economy seems to be doing pretty well. If we look to the last leading indicators report it was the largest increase since March of this year. It's the sixth straight gain, and it is at the highest level since October 2007. Essentially it has gotten back to where we were seven years ago.

However, I don't think that U.S. economic growth is likely to accelerate dramatically any time soon. We see Gross Domestic Product rising 2.1 percent this year compared with our forecast at the beginning of the year of 2.8 percent.

What has changed primarily was the depth of the first-quarter decline as well as an expected moderation of the second quarter initial report showing the 4 percent increase.

Finally, our 2015 estimate is 3 percent growth, which is also slightly lower than our earlier estimate of 3.2 percent -- not much of a difference -- because housing has not recovered as quickly as we first thought, as well as refined forecasts for global economic growth, therefore expected export demand.

In summary our GDP forecasts continue to point to a good global recovery but not a great one.

Q: There's a debate among Federal Reserve members about unemployment: Is it cyclical or structural, the answer supposedly determining the potential of economic growth. Where do you stand?

A: It certainly feels as if it's structural, because of the time it's taken for the number of people to recover their jobs as compared with our last expansions. At the same time, I think people would question the quality of those jobs.

With the most recent speech by Fed chairman Janet Yellen she basically reminded us that while the headline unemployment number looks increasingly respectable as it approaches the 6 percent threshold, the broader measure of unemployment, under-employment, and disgruntled job seekers -- the U6 -- remains close to twice as high.

Underlying her comments, in my opinion, is a confession is that the Fed has had more practice fighting inflation than it has fighting deflation, which infers that the Fed might me more willing to be behind the curve than ahead of the curve.

Q: Will the Fed raise interest rates in mid-2015, in spite of a minority of members who want it faster because of fear of rising inflation, which many feel does not exist?

A: It's interesting how people automatically assume that because the Fed has been filing the pipelines with liquidity that it will automatically lead to hyper-inflation. That makes me think of the analogy that if Hostess doubled the output of Twinkies, and nobody ate them would we still gain weight?

We are not of the opinion that inflation will be taking off any time soon. We saw inflation up 1.5 percent for all of 2013. We think it will be up 1.9 percent in all of 2014 and remain below 2 percent for all of 20915.

Wage growth continues to track lower than headline inflation, implying that the consumer continues to lose purchasing power, so I don't think the Fed wants to exacerbate the situation by taking an aggressive policy stance toward interest rates.

Our expectation is that the Fed will start to raise rates by the middle of next year and will do so fairly gradually. It will help push the yield on the 10-year Treasury note from an average of 2.4 percent in 2013 to 2.7 percent this year and 3.3 percent next year.

Q: What does that imply?

A: That 's an interesting question, because when the yield on the 10-year note broke below the technically important 2.4 percent level the implication became that it might challenge the 2 percent level before it re-challenges the 3 percent level. Many nervous investors took that as a hint that economic growth will likely be under expectations and that a sharp sell-off in the stock market is right around the corner.

But I believe that the Treasury is very much a global bond and as a result the yields reflected global investor interest in a more attractive yield that what could be found in Europe and a more secure market than what could be found in the emerging nations/. So I don't necessarily think that it's a reflection of nervousness about the U.S. economy rather than opportunistic global fixed-income investors looking for safety and yield.

Q: Can stocks keep rising without taking a breather, and, if so, when might that happen?

A: The S&P 500 has gone almost 35 months without a decline of 10 percent or more. The median time between such declines since World War II has been 12 months, so we have gone nearly three times as long as we normally do. What's more, following the four times that the market went longer between such declines, in three of the four the next sell-off resulted in a bear market. So, I would prefer that we reset the dials sooner rather than later, as it may improve the chance that we get away with a correction rather than a new bear market.

In terms of valuations, however, whether you look to projected earnings or trailing earnings, the S&P 500 is trading smack dab on long-term average valuations, so one couldn't really say we are trading in nosebleed territory and as a result need a sell-off to return us to more normal valuations.

I expect the S&P 500 to reach a minimum of 2,100 by this time next year, based on what I call the "rule of 20," which says that inflation plus the market's price-to-earnings ratio - based on GAAP or As Reported earnings - equals 20 in a fairly valued market. Using bottom-up EPS growth estimates, I come up with 2,100, yet 2,200 when looking at top-down earnings estimates.

This disparity is also quite interesting because bottom-up, or analyst-driven estimates, are usually more optimistic than top-down, or strategist/economist-driven estimates. So, depending on whom you believe, the market could be up between 5.5 and 1.5 percent by this time next year.

Q: How risky to the U.S. economy are Europe and deflation?

A: I think that European deflation is a big worry for the global economy as well as for the U .S. economy, and I believe the markets will be disappointed if we don't get either action or less subtle hints by the European Central Bank by mid-September of a quantitative easing program like the one in the U.S.

I think the second-quarter GDP decline in Germany and the flat reading for France was a reminder that Europe could easily fall back into either a recession or a period of very sluggish growth.

I think that if the countries move away from austerity, and if they believe that growth can occur organically, and, as a result, that revenues can be used to pay off growth, it doesn't necessarily matter how a country strengthens its economy. Preferably it will be done through expansionary activity rather than austerity measures.

Q: Why haven't all of the military actions from the Mediterranean to the Black Sea not led to a market decline?

A: While these in many cases are humanitarian tragedies they aren't likely to affect global economic growth. As a result, while the market might experience a couple of days of weakness as a result of uncertain actions by Russia, in the end, the flow of energy and exports would need to be interrupted before Wall Street really sits up and takes notice..

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.