With A Strengthening Economy In Hand, Markets Should Do Well Near Term

|
Includes: DIA, SPY
by: Eric Petroff

Summary

Many economic indicators show GDP growth is recovering.

Manufacturing indices and consumer spending are picking up speed.

Overall housing market activity is a positive to GDP growth.

Investors should be prepared for short-term gains, but we remain in a low return environment.

Contrary to many economic indicators during the winter, it appears we are not heading into a contraction based on the latest data and should see a recovery in GDP growth for 1Q 2016. We believe this because the recent decline in ISM PMI indices has turned into an expansion, the unemployment situation continues to improve, consumer spending is picking up speed, and the Federal Reserve has effectively reiterated its commitment to low rates for the time being.

It is understandable how just a few months ago one could think the economy may have been heading into a period of slow growth to contraction. We saw weakening total business and retail manufacturing sales and an increasing personal savings rate that slowed growth in personal consumption expenditures. There was also falling consumer confidence, a decline in new home sale prices and most importantly, real 4Q GDP continued on a three-quarter decline.

However, these metrics appear to be turning around. Total business and retail manufacturing sales made a jump in January, the ISM PMI, new orders and production indices are all in expansionary territory, and even though the personal savings rate keeps rising, one-year growth in personal consumption expenditures is up a decent amount for January and February. We also expect the Consumer Confidence Index to rise as it has previously, following winter months.

It is also worth noting that GDP growth rates have been cyclical the last few years, dropping in the winter months and rising during the spring and summer. Moreover, the International Monetary Fund (IMF) has a positive outlook on the US economy. As of January, the IMF has placed the US economy at the top of the developed world for 2016 and 2017 and not too far behind emerging market economies that usually have a significant nominal advantage in growth rates.

Another positive area worth discussing is labor markets. This portion of the economy has received a lot of bad attention recently due to historically low labor force participation rates, but this metric has actually risen a little in recent periods, but it remains near historic lows. The unemployment rate also keeps falling and is at prerecession levels, initial unemployment claims keep dropping and average hourly earnings are trending higher.

However, even with this positive news, it is very unlikely the Federal Reserve is going to increase interest rates anytime soon. The Federal Reserve wants to see higher labor force participation rates and wage growth, and is also concerned about the effects of rising interest rates on the global economy and how that could drag down US GDP growth in the process. So for the time being, monetary stimulus should continue to remain in full force.

Given the Fed Funds rate and mortgage rates are going to remain low for the foreseeable future, there is little reason to be worried about any sort of a slowdown in real estate markets. Yes, we may have seen a decline in new home sales in recent periods and both median and average home sale prices dropped in the last few months, but there already appears to be a recovery in these metrics for the early months of this year.

Another major positive for real estate markets is that there is an overall increase in market activity. We can see this from the steady increase in the number of homes for sale and the median number of months it takes for a new home to be sold. In fact, the amount of time it takes for a new home to be sold is now down to historically low levels over the last twenty years and is a small fraction of what it was during the height of the recession.

So all in all, we firmly believe that the US economy is going to have a good first quarter this year in spite of recent concerns that we may see a manufacturing led contraction in GDP. With this in mind, we would expect capital markets as a whole to perform relatively well in the coming quarter. This is because the economy should grow faster than recent periods, interest rates are not likely to rise near term and GDP growth should help corporate earnings.

However, the likelihood of seeing any meaningful gains near term in bonds is not that strong. Given interest rates have fallen in recent periods due to equity concerns, yields are lower than they were a quarter ago and will provide modest returns at best. On top of this, we should expect interest rates to rise a little in the coming months due to strengthening GDP and more assets flowing back into equity markets, which could easily offset interest income.

Equity markets are a different story as they are much more sensitive to changes in the underlying economy, which was presumably evidenced by strong March gains as improving economic data has been released in the last month or two. Within equity markets there appears to be a few areas of opportunity to bolster returns. More specifically, MSCI EAFE and emerging markets stocks look relatively cheap in comparison to US markets.

On the whole, the situation investors are facing has not changed materially the last quarter. We remain in a poor return environment with low interest rates and overvalued US equity markets by historic standards. This puts investors between a rock and a hard place because there is no apparent reason to get out of markets near term, but staying fully invested going forward will likely produce modest portfolio gains given expensive capital markets valuations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.