Sloppy Markets Continue
June 17, 2013
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Last week the S&P 500 declined 0.97%, while many global equity averages fell for the fourth week in a row.1 Early in the week, discussion of tapering by the Federal Reserve was a big headwind, as discomfort over a slower pace of policy accommodation rippled through global markets. Thursday’s rally was driven by thoughts that tapering fears may be overdone. Markets were also helped by better employment and consumption data.
Mixed Signals
Two weeks ago, we mentioned that the market seemed due for a rest. We cited the potential for a 7 to 10% correction for the S&P 500 to approximately 1550, or a consolidation in the 1600s, both more likely than continued strong markets with new record highs before July 4. In our view, the upcoming decision to taper Fed purchases as a result of stronger real growth should be seen as a welcome and necessary step toward recovery, rather than something to be feared.
The sell-off in bonds over the last month may have reached a short-term pause. Real yields are positive for the first time in almost two years,2 while inflation expectations continue to fall. U.S. fundamentals remain mixed, with steady labor markets in May despite the drag from sequestration and global economic softness. The underlying U.S. story remains positive — a combination of the wealth effect, strong corporate balance sheets and pent-up demand as measured by aging capital stock.
Weekly Top Themes
- Retail sales increased 0.6% in May, which was slightly better than expected:3 Consumer metrics look reasonably healthy, as spending growth has been modest but steady, even while fiscal headwinds challenged household incomes.
- The average inflation in advanced economies fell to only 1.3% in April, the lowest rate since 2009:4 With the recent decline in commodity prices, further inflation declines could happen.
- Rising equity prices and housing price gains raised the value of household assets to a record high in the first quarter:5 Through the wealth effect, rising equity and house prices have kept consumption reasonably strong.
- The federal budget deficit decline prompted S&P to upgrade its outlook for U.S. debt:6 Complacency in Washington, D.C. may have closed the window for significant entitlement reform, making the task more difficult to address later this decade.
The Big Picture
The recent equity sell-off was likely triggered by Fed dialogue about an earlier slowing of its large-scale asset purchases. All eyes are now on this week’s FOMC meeting and Fed Chairman Ben Bernanke’s press conference. Our guess is that Bernanke will try to avoid committing to the timing of tapering, emphasizing that the decision remains dependent on data, and tapering is not the same as hiking interest rates. It is possible the Fed will lower its growth and inflation forecast. The Fed’s trial balloon about a potential reduction in quantitative easing has many challenges.
Inflection points in monetary policy often have the potential to trigger a rise in financial market volatility. This exists today, especially with fixed income prices distorted by Fed policy. Rising U.S. Treasury yields should not have a lasting impact on the equity market, to the extent that the rise reflects brightening of the economic outlook rather than inflationary pressure. We remain cyclically bullish on equities, but near-term caution is warranted. The modest pullback has been insufficient to unwind technical conditions. The two main catalysts for a correction are early tapering and weak growth around the world. The U.S. economy is steadily expanding, Japan continues to fight inflation, Europe remains in recession and China is experiencing softer growth than usual. A grinding government bond bear market is finally underway and should help trigger an eventual change in equity leadership. As Treasuries sell-off, safe haven and higher-yielding investments may lose appeal. We believe investors may begin looking for economic-sensitive risk assets with solid underlying fundamentals. We prefer stocks focused on business spending, including technology and capital goods producers.
1 Source: Morningstar Direct and Bloomberg, as of 6/14/13.
2 Source: Business Insider, “There’s One Chart Responsible For The Tectonic Shift In Global Markets,” June 12, 2013, http://www.businessinsider.com/ us-real-rates-rise-central-to-world-markets-2013-6.
3 Source: U.S. Census Bureau, “Advance Monthly Sales for Retail and Food Services, May 2013,” June 13, 2013, http://www.census.gov/retail/.
4 Source: Bureau of Labor Statistics, “Consumer Price Index – April 2013,” May 16, 2013, http://www.bls.gov/news.release/cpi.nr0.htm.
5 Source: Reuters, “U.S. household wealth increases by $3 trillion in first quarter,” June 6, 2013, http://www.reuters.com/article/2013/06/06/usa-economy-debt-idUSW1N0DP00J20130606.
6 Source: cnbc.com, “S&P Revises US Credit Outlook to ‘Stable’ From ‘Negative’,” June 10, 2013, http://www.cnbc.com/id/100791461.
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
Conflicting Crosscurrents
June 10, 2013
U.S. equities finished 0.83% higher last week,1 with a rally on Friday driven by the May employment report that was in line with expectations. The week was dominated by a continued flurry of headlines: possible Fed tapering, global monetary policy credibility, quality of the U.S. economic recovery, sensitivity to rising rates for housing and stock prices and overall investor sentiment.
Waiting to Confirm Self-Reinforcing Economic Growth
We believe there is widespread but misguided concern that a shift away from current extreme monetary policies would signal the end of the U.S. equity bull market. In our view, the concern is misguided because it ignores the main reason the Federal Reserve has been priming the pump – the economic environment has been fragile with lingering high debt levels, risk averse business behavior, constrained fiscal policy and below target inflation. A return to a healthier economic climate that allows a normalization of monetary policy should provide signs of a bull market for risk assets, rather than a bear market. A monetary exit, whenever it comes, will likely be messy. Stocks and bonds could suffer as investors realize the hyper-accommodative monetary environment is coming to an end. But, in our opinion, any setback for stocks would be temporary, given that overall expectations about the economy and earnings would be improving.
Weekly Top Themes
- Nonfarm payroll rose 175,000 in May, slightly ahead of the consensus:2 The service sectors were the key growth driver, and manufacturing was weak. The unemployment rate moved up to 7.6%, while average hourly earnings were flat, which was a disappointment.
- The manufacturing Purchasing Managers’ Index (PMITM) fell to 49.0% in May:3 Since the prior report data was 50.7%, this was much weaker than expected. The cold weather during the spring and fiscal restraint from sequester is weighing down the economy. We continue to expect the manufacturing economy to gradually improve in the second half of the year as fiscal and foreign issues moderate.
- Approximately 80% of the S&P 500 companies that provided outlooks for the second quarter issued negative guidance:4 Expectations for growth in earnings remain 1.3% for the second quarter.
The Big Picture
A full employment and economic recovery seems years into the future based on current high levels of unemployment, projected high long-term unemployment and under-employment. Since core inflation is now at the lowest level on record, we are puzzled by the mention of tapering by the Fed. The Fed has yet to achieve either side of its dual mandate: 1) inflation is below target, and 2) unemployment is still too high to warrant taking economic risk. Therefore, a period of catch-up growth is needed.
The consumer economy has seen a rebound as unemployment has fallen, balance sheets have repaired and home values have bottomed. On the corporate side, businesses remain hesitant to put cash to work and continue to act cautiously. Fed Chairman Ben Bernanke has made it clear that the central bank will only move after the economy performs well for an extended period, which would correspond with improving sentiment toward corporate profits. There is skepticism and distrust of the cyclical advance in stock prices, cash levels remain high and retail investors have just begun to relocate funds into equities. Compared with a few months ago, investors are definitely feeling better but not euphoric. We believe investors should prepare for more choppiness this summer as the market sifts through what is likely to be mixed fundamental and economic data.
1 Source: Morningstar Direct, as of 6/7/13.
2 Source: Bureau of Labor Statistics, “The Employment Situation – May 2013,” June 7, 2013, http://www.bls.gov/news.release/empsit.nr0.htm.
3 Source: ISM, “May 2013 Manufacturing ISM Report On Business®,” June 3, 2013, http://www.ism.ws/ismreport/mfgrob.cfm.
4 Source: FactSet, “Earnings Insight,” June 7, 2013.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.