Economic Outlook: Finding Reason for Optimism in a Mixed Bag
- There is some evidence that market conditions have stabilized some in the oil patch. The four-week average of jobless claims in Texas hit its highest point in late February and has backed off to lower levels subsequently.
- More broadly, however, the economy may be in somewhat of a soft patch right now. We talked about the first quarter GDP numbers last week. We follow a couple of trucking and freight indexes that give some good insight into activity in the real economy. These remain positive on a year-over-year basis. However, they are not as strong on this comparative as they were six months ago.
- May auto sales came in strong at 17.8 million units on an annualized rate. We have not seen those kind of numbers since before the Great Recession.
- Where is the consumer spending? In addition, May’s Manufacturing PMI Index showed an increase over April and Personal Income moved up in April to an all-time high. We’re just waiting to see if the consumer is going to be willing to spend some of that increased income.
- So far, it appears many are saving the extra money. An interesting tidbit from Hearts & Wallets, a financial research firm on why consumer spending may not be picking up: Baby Boomers who are financially supporting their adult children total 8 million households. These adult children who are on Mom and Dad’s dole will not spend the same way they would if they were productively working. Nonetheless, far too early to call for the demise of the U.S. consumer.
- The U.S. economy may indeed represent somewhat of a “mixed bag” right now. Someone once quipped: “The ideal man doesn’t smoke, doesn’t drink, doesn’t do drugs, doesn’t swear, doesn’t get angry – and doesn’t exist”. That may be true when looking for the “ideal economy”. Economic data reports are not uniformly perfect, but on balance, we like what we see.
- Quantitative Easing in Europe seems to be producing some of the desired effects the ECB hoped for. Despite the Greek distraction, the weak currency has boosted the manufacturing economy. Retail sales in the Euro-zone are up 2.2% on a year-over-year basis. We actually saw a bump in rates in Europe’s bond markets last week as the fears of deflation seem to be waning a bit.
Equities Outlook: Two Questions That Really Matter
- When we look ahead in the U.S. equity market and attempt to assess the potential to get good return on capital, there are essentially two questions that matter. What multiple on average must we pay to buy the shares of good businesses? And what is the outlook for profit growth by those businesses in the coming years?
- We’ve discussed the first question several times recently. The market multiple on the S&P 500 universe of large U.S. companies is running in the high 16s compared to forecasted earnings in the next 12 months. That is not terribly expensive in a time of low interest rates and low inflation, but it cannot be called a bargain either. Therefore, you’d have to say stocks today are selling for what looks to be a “fair” price.
- On the second question, there seems to be a low likelihood of an economic recession that would present any major challenges to U.S. corporate earnings growth. However, companies have improved their profit margins nicely as we move through the seventh year of this recovery. There’s probably not any additional increase in margin to be had out there. That leaves us with a conclusion that earnings growth is likely to track U.S. economic growth. Nominal growth, which includes inflation, has averaged 7.0% per year since 1960. More recently, with lower inflation, it has been closer to 5.0% per year.
- Put all that together. Market multiples don’t have a lot of room to expand. Corporate profits might tend to move in line with U.S. nominal economic growth. This suggests that stocks, on average, could return something in the 5.0% – 7.0% per annum range in the next few years. Those are not numbers that cause your heart rate to rise, but on the other hand, with low inflation running around 2.0%, it suggests a “real” return on capital of 3.0% to 5.0% per year for equities, actually not far off the long-term norm.
- We are also seeing a large volume of merger and acquisition activity in the market, which creates some additional opportunistic return potential for investors in U.S. equities. The value of announced “deals” in the first five months of the year is approaching $800 billion, which is half of where we were at this point in 2014.
- We’ve talked a good bit recently about the opportunity overseas. Asking the same two questions about European equities calls for different answers. European markets are at significantly lower multiples of forward earnings compared to the U.S. In addition, corporate profit margins are not anywhere near their previous highs, leaving lots of room for growth in earnings from margin improvement. Moreover, earnings are accelerating.
- We continue to like the opportunity set presented in overseas equities.
Fixed Income Markets: Conviction and Doubt
- There was an increase in yield on the 10-Year Treasury note at the end of last week, as it closed at 2.41%, up a full 20 basis points from where it finished the previous week.
- Fixed income investors seem to be able to look at all of the economic data and conclude that there is some underlying strength.
- However, the fact that Treasury yields have not really broken out suggests that fixed income markets still harbor a significant degree of doubt regarding whether demand in the economy is strong enough to lead to a pickup in inflation.
The Week Ahead
- JOLTS Survey Release
- Initial Jobless Claims
- U.S. Retail Sales Report
- PPI Inflation Report