(Yawn)...As Equities Advance Another 2%
May 20, 2013
U.S. equities advanced again last week, with the S&P 500 increasing 2.1%.1 Global stocks are reaching new highs in this cycle and the U.S. market is at an all-time high. Bonds were hurt in the move, dragging credit down, while commodities fell slightly on weaker manufacturing data. The unrelenting equity rally and an environment without positive news about earnings and the economy is making many investors uncomfortable.
Investors Are Still Awake at Night
Unprecedented monetary reflation, including the suppression of interest rates and rate expectations seem to have gradually spurred investors to move along the spectrum toward higher risk assets. Global economic prospects have also improved because of increased odds that Japan will finally escape deflation. The end point of the massive monetary experiment will be better economic growth, even though the path has not been smooth and will remain historically slow to develop. It has been difficult to spark a global trade upswing, given the recession in Europe and flat revival in emerging market growth.
There is certainly no shortage of things to worry about – investor confidence has been repeatedly undermined by bank turmoil, debt crises and double dip recession scares. Although monetary authorities are battling hard against the forces of debt deflation, their efforts to reflate economic conditions have resulted in the use of aggressive and unorthodox policies, thus increasing uncertainty and fears regarding the ultimate conclusion. In our opinion, stocks remain undervalued in relative terms despite the extended bull market. This is especially true given that the economic backdrop continues to slowly improve.
Weekly Top Themes
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Broad-based inflation weakness was revealed by the April Consumer Price Index (CPI) report:2 The headline inflation number fell 0.4% for the month; core inflation rose 0.1%. For the trailing twelve months, headline inflation was up 1.1% and core inflation up 1.7%. These were the smallest 12-month increases since 2010.
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The University of Michigan Consumer Sentiment Index was up 7 points to almost 84 in the preliminary May report:3 The latest reading was still low by historical standards; however, it was the best thus far during the expansion. We have been surprised by the resiliency of consumer spending in the face of the tax increase that began at the start of the year. The recent improvement in sentiment appears to be a positive sign for consumption as we look ahead.
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A new report from the Congressional Budget Office suggests that deficits are likely to grow at a much slower pace in 2013 and 2014:4 Since deficit spending has been seen to be a major impediment to economic growth and the stock market, this was good news for the economy and the market.
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The biggest challenge for the Obama administration is legislative activity because this year should be the sweet spot in its second term: The recent scandals, combined with animosity created by the fiscal cliff negotiations, could sink the legislative agenda on Capitol Hill. However, this may not equate to a negative for equity markets because the improving deficit is pushing off the debt ceiling issue by six months.
The Big Picture
We have witnessed one of the biggest mid-cycle re-ratings of global equities in over forty years. U.S. stock prices have rallied more than 30% since the 2011 lows, while earnings have been almost flat and dividends have increased.5 Although we believe equities still look cheap compared to bonds and cash, equities no longer appear inexpensive when comparing to their own history. We anticipate markets will make further gains, supported by moderate earnings growth and dividend increases, but valuations now imply less impressive gains moving forward. Equities and bonds should sell off if the Fed hints at a reduction in its monthly bond purchases. In the meantime, the rise in equities, decline in gold, stronger U.S. dollar and uptick in Treasury bond yields make sense in the context of slowly improving economic growth.
1 Source: Morningstar Direct, as of 5/17/13.
2 Source: Bureau of Labor Statistics, “Consumer Price Index – April 2013,” May 16, 2013, http://www.bls.gov/news.release/cpi.nr0.htm.
3 Source: Bloomberg, “Consumer Sentiment Index in U.S. Rose to 83.7 in May,” May 17, 2013, http://www.bloomberg.com/news/2013-05-17/consumer-sentiment-index-in-u-s-rose-to-83-7-in-may-from-76-4.html.
4 Source: Congressional Budget Office, “Updated Budget Projections: Fiscal Years 2013 to 2023,” May 14, 2013, http://www.cbo.gov/publication/44172.
5 Source: FactSet and Standard & Poor’s, as of 5/17/13.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.
Last Week's Commentary
Cyclical and Emerging Market Strength May Be Pointing to Better Growth
May 13, 2013
Last week U.S. equities advanced as the S&P 500 increased by 1.3%.1 We have been amazed by the market’s ability to continue to rally in an environment in which sales growth has been anemic and earnings gains have been largely based on companies’ abilities to manage margins and utilize financial engineering.
Awaiting the Self-Reinforcing Expansion
Despite a lackluster economic and profit backdrop, there are growing expectations that the Fed will continue with open liquidity taps, intensifying the search for yield and forcing investors into equities. It seems that corporations are taking advantage of this yield hunger by issuing debt, levering up their balance sheets and returning cash to shareholders. A greater risk for the global economy appears to be deflation. While quantitative easing by the Fed and other central banks may eventually result in higher final goods prices, a more immediate result may be higher prices for risky financial assets, especially equities.
Another critical issue is whether growth will falter again. We believe the chance of a growth relapse is relatively low. The housing recovery alone is only a small plus for the overall economy. Its effect on consumption, government revenues, improved collateral values, and a slowly-healing monetary transmission mechanism will help create a self-reinforcing expansion, although we believe the recovery could remain less vigorous than in past cycles. Until housing reached its trough, the economy could not begin to recover, and now further housing price gains and sales will continue to provide a modest economic tailwind.
Weekly Top Themes
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Initial filings for jobless claims declined again, setting a new low for the cycle:2 The jobless claims fell by 4,000 for the week ended May 4, 2013. Since claims have now fallen three weeks in a row, this continues to send a reassuring signal about the health of the labor market. If claims can hold near current levels or fall further, we would anticipate a solid increase in private sector job creation.
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The Fed’s latest Senior Loan Officer Opinion Survey showed easing in lending standards and increases in demand for lending categories:3 The report was somewhat of an improvement, but reflects continued modest economic growth. The Fed survey tends to have a one-year lead on S&P revenues.
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The macro tail risk from Washington continues to decline as the debt ceiling breach has moved from July to most likely October:4 The improvement is a result of higher than expected receipts from the expiration of the payroll tax credit and the tax raises associated with the fiscal cliff deal. This is likely to provide a much longer runway than was previously anticipated, and U.S. political issues should have less of an impact during the second and third quarters.
The Big Picture
We believe the market is suggesting improvement in the economy, not only by appreciation but also by internal action. In our opinion, factors generally associated with a cyclical upswing, such as beta and leverage, have begun to outperform for the first time this year, while those offering stability are starting to lose some steam. The next part of the story unfolded at the sector level two weeks ago, when cyclicals began to outperform while defensive sectors started to falter. For example, information technology, energy, financials, industrials and materials are all outperforming the broad market while consumer staples, utilities, health care and telecom are lagging.5
For equities, we believe the trend continues to be upward. For the bond markets, we expect a continued upward tilt in yields. Commodities are likely to continue to struggle until global economic activity is more robust. Higher dividend stocks and defensive stocks have become relatively expensive, and in our view many cyclical companies and emerging equity markets offer good value in a low growth world. We expect this shift to continue only if global economic growth improves, and more evidence is needed for those trends to continue.
1 Source: Morningstar Direct, as of 5/10/13.
2 Source: Bureau of Economic Analysis, “The Employment Situation,” May 3, 2013, http://www.bls.gov/news.release/empsit.nr0.htm.
3 Source: The Federal Reserve Board, “The April 2013 Senior Loan Officer Opinion Survey on Bank Lending Practices, April 2013, http://www.federalreserve.gov/boarddocs/snloansurvey/201305/default.htm.
4 Source: New York Times, “House Vote on Debt Ceiling Gives Priority to Creditors,” May 9, 2013, http://www.nytimes.com/2013/05/10/us/politics/house-votes-to-give-creditors-priority-if-debt-ceiling-isbreached. html.
5 Source: FactSet, as of 5/10/13.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.