Economic Growth and Inflation
Are Both Moving Higher
May 23, 2016
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Investor attention has been focused on the Fed, as the prospects have risen for an earlier-than-expected rate increase.
Despite weak earnings results, we believe consumer spending remains solid, which should help the broader economy.
Corporate earnings should improve in the second half of 2016, providing a tailwind for equity prices.
U.S. equities were mixed last week. The S&P 500 Index snapped a three-week losing streak and climbed 0.4%, while the Dow Jones Industrial Average was down fractionally.1 The biggest story last week was a growing sense that the Federal Reserve might begin raising interest rates sooner than previously anticipated. Corporate earnings were also in focus, with retailers continuing to show poor results.
Weekly Top Themes
The minutes from the April Fed meeting were slightly more hawkish than anticipated. The Fed indicated that markets were overly complacent about the prospects for near-term rate hikes. The Fed continued to suggest that two rate hikes might occur in 2016, but there appears to be a greater possibility of the first increase happening as early as June or July.
Fears of deflation have eased significantly since the beginning of the year. Global growth has shown signs of improvement, worries about China devaluing its currency have faded and oil has rebounded notably. All of these factors have dramatically reduced global deflationary risks.
Inflation is slowly starting to advance. The Consumer Price Index rose 0.4% in April, the sharpest increase since February 2013.2 Gasoline prices showed a dramatic rise of 8.1% for the month.2 In our view, the recent increase in commodity prices should push headline inflation to around 2% during the second half of this year.
Despite weak earnings from retailers, overall consumer spending remain solid. A main corporate earnings theme for the first quarter was pronounced weakness in traditional brick-and-mortar retailers, particularly clothing and department stores. Overall retail sales, however, appear to be growing. Part of this apparent disconnect is due to the fact that consumers are still spending money on online purchases and in areas such as home improvement. Second quarter retail sales are on track to increase at a 5% annual rate (in line with the first quarter).3 And consumer spending may rise from 1.9% in the first quarter to close to 2.5% in the second quarter.3
Although consumers are spending money, the savings rate is also rising. Just before the Great Recession, the U.S. savings rate was 2.5%, and it has since risen to over 5% today.3 This stands in marked contrast to a decades-long trend: From the mid-1970s through the beginning of the Great Recession, the savings rate trended lower as Americans spent beyond their means.3 The fact that U.S. consumers now have both healthy savings and spending patterns is good news for consumer spending and the broader economy.
Equity Market Variables Include Fed Action and Earnings
The Fed’s suggestion last week that additional rate hikes were on the horizon should not have come as a surprise, yet markets experienced a minor jolt. Investors remain wary about higher interest rates and continue to react (and overreact) to every Fed statement and hint. In some ways, the Fed itself is to blame for this phenomenon. The central bank waited so long (we would say too long) to enact its first rate hike in December, and has been highly attuned to financial market conditions as it ponders its decisions.
The Fed has clearly stated that any future moves will be data dependent. And additional rate hikes seem inevitable since economic growth appears to be improving and inflation is starting to rise. The exact timing, however, is unclear. The Fed is in a conundrum since it does not want to rattle investors, but is aware that rate hikes will do just that. When the next rate hike does occur, we expect it will cause additional market volatility, but we also believe that the economy and equity markets should be able to overcome any turmoil.
The main catalyst for equity prices remains the earnings backdrop. The quality of earnings has deteriorated over the past several quarters, but we do not believe corporate health is failing. As global economic growth regains traction, we expect earnings will improve, especially if we do not see a renewal of the oil rout/dollar rally trend. Equities are not inexpensive at present levels, but valuations are not stretched. Assuming corporate earnings can recover, we think it is more likely than not that equity markets will advance over the coming year.
1 Source: Morningstar Direct, as of 5/20/16
2 Source: Labor Department
3 Source: Cornerstone Macro
Last Week's Commentary
Long-Term Positives Outweigh
Negatives for Equities
May 16, 2016
Despite recent negative headlines from the retail sector, we believe consumer spending remains on track and should be a tailwind for the broader U.S. economy.
Market volatility is likely to persist, but we think equity prices will grind higher as corporate earnings results improve.
The S&P 500 Index fell 0.4% last week, although it remains in positive territory for the year.1 The retail sector was a heavy focus last week as earnings results were broadly disappointing. The cancellation of the Staples/Office Depot merger also caused sentiment to sour on retailers. The rally in the U.S. dollar continued, as U.S. growth continues to outpace most of the rest of the world.1 Oil prices rallied while most industrial metals were lower.1
The Consumer Sector Should Help Drive Economic Growth
Disappointing first quarter earnings results from many large retailers have been causing some to question the strength of consumer spending. Economic data from last week, however, showed some positives for the consumer. April’s retail sales figures showed a 1.3% increase, notably higher than the consensus expectations of 0.8%.2 Likewise, the latest reading of the University of Michigan’s Index of Consumer Sentiment rose from 89 in April to 95.8 in May, its highest level in eleven months.3
In our view, these readings help reinforce the notion that the consumer sector remains quite healthy despite some earnings struggles. A possible slowdown in employment growth should be counter-balanced by rising wages. We believe consumer spending remains an important tailwind for the broader economy, which we expect should continue to grow close to 2%.
Reasons for Optimism...and Pessimism
Rather than our usual weekly economic and investment themes, this week we offer a list of reasons to be optimistic about the economy and equities, as well as a list of reasons to be pessimistic, adapted from some thoughts by J.P. Morgan Research.
On the positive side, we would include:
- Equity valuations do not appear to be stretched.
- Earnings improvements should start to materialize in the coming quarters.
- The oil rout appears to be over.
- Investor sentiment may be overly bearish.
- Corporate tax reform prospects for next year appear bright.
In contrast, the negatives include:
- Earnings remain shaky and improvements are probably necessary for equities to experience a sustained move higher.
- Investors may be overly complacent about Federal Reserve rate hikes.
- Global growth is likely to remain anemic.
- The U.S. political backdrop is highly uncertain.
- Regulatory scrutiny over mergers and acquisitions appears to be growing, which may suppress this equity-friendly activity.
Despite a Solid Outlook, Sentiment Remains Depressed
A back-and-forth in markets has been the theme that has dominated 2016. Markets pulled back over the past several weeks after rallying from mid-February through mid-April. In retrospect, it shouldn’t be surprising that this rally faded. Investor sentiment has remained weak and investors are defensively positioned, continuing to hold large amounts of cash. This suggests the recent rally was a result of short covering and a sense that recession and deflation risks were fading, rather than coming about through growing optimism. In other words, investors may believe that conditions aren’t as dire as they thought early in the year, but they are hardly optimistic about earnings and economic growth prospects.
Overall, we think the positives will win out over the negatives, but near-term concerns mean risk assets are unlikely to move up in a straight line. The current risks and hurdles include next month’s referendum on whether the U.K. will leave the European Union, the prospect of a more aggressive than expected pace of Fed rate hikes and the possibility of another downturn in oil prices. We think the odds are better than not that markets will weather these potential storms. But given the fragile state of sentiment, it wouldn’t take much for equities to experience another sell-off or consolidation.
Ultimately, we think investors need evidence that corporate earnings have recovered before they will feel more comfortable moving back into equity investments. We expect this evidence will materialize over the coming quarters, which is why we believe equities will outpace bonds and cash over the next six to twelve months. But investors will be slow to embrace good news and there is still ample reason for caution. As such, we think volatility will remain elevated.
1 Source: Morningstar Direct, as of 5/13/16
2 Source: Commerce Department
3 Source: University of Michigan