Market Insights: October 1, 2013
Economy: Sorting through mixed signals…
- Consumer confidence numbers declined modestly last week [The Conference Board]. Apparently the headline risks (debate over debt ceiling, Obamacare, and government funding) from Washington are exacting some toll on consumers’ moods.
- However, the same survey showed increases in the “intentions” sub-components. Home-buying plans and auto-buying plans both increased. People may have a sour mood, but they are not yet hunkering down with their wallets.
- Despite higher mortgage rates, rising home values have lifted large numbers of homeowners out of their negative equity positions. Final July home price values are up 12% over one year ago [Case-Shiller Index].
- Homebuilders are selling completed homes in average of 3 months, an improvement from 5-6 month wait that posted 1 to 2 years ago [National Association of Homebuilders]. However, the pace of growth in pending home sales (new contracts signed) has slowed to +2.9% [National Association of Realtors].
- Initial jobless claims fell last week to the 305,000 level, which was lower than economists expected. This is usually a good leading indicator of the direction for the economy [Bureau of Labor Statistics].
- Report on Personal Income released for August shows Personal Income up 3.7% over year-ago levels.
- The data is now complete to calculate Real Final Sales for the second quarter. This is the growth in GDP, excluding inventory changes. The final figure shows growth of 2.1% annually. This is a big pickup from the first quarter which was flat.
- Europe continues to show strength. As we expected the European flash PMI Composite came in last week at an increase – 52.1. This is a 27-month high.
Equities Outlook: Boiling it down…
- Can we boil this market down to something simple? Ask 3 questions:
- Is the U.S. economy growing or shrinking? Growing
- Is inflation low or high? Low
- Is the Fed accommodative with liquidity? Yes!
- This is no change from the last few years and an upward bias in the stock market is the most likely case for the intermediate term.
- New York Fed President William Dudley was quoted last week indicating he believe the Fed should remain highly accommodative.
- That said, there remains vulnerability to correction in the short term. The S&P 500 is priced at about 14.5 times forward earnings, near the average that has prevailed for the past decade. Stocks are not expensive, but likewise they are not cheap. This could mean a “lull” in the near-term with some risk of correction should the headline risks go the wrong way.
- Correction risk is important in decisions to deploy new cash but should not alter strategy for investors with longer-term time horizons.
- Core Eurozone markets have begun out-performing the U.S. market in the third quarter. Germany, France, and the Netherlands are up 12.9%, 15.6%, and 15.7% respectively. Even the markets in troubled Italy and Spain were up more than 20% off their very low valuations. Price to book value ratios for stocks in Spain and Italy are 1.0X and 0.9X.
The Fed and Fixed Income Markets: If something cannot go on forever…
- Treasury yields have drifted a bit lower. The 10-year note closed the week at 2.62% after nearly piercing the 3.0% barrier a couple of weeks ago. This looks like a relief rally.
- This does not change our view that we have entered a new phase in fixed income investing. The ever-declining interest rates and ever-declining inflation rates of the past 32 years have likely ended and are now beginning a reversal.
- Remember Herbert Stein’s “Law”: “If something cannot go on forever, it will stop.” [Herbert Stein was Chairman of the Council of Economic Advisers under Presidents Nixon and Ford].
- This change does not mean that interest rates and inflation will move up quickly, however. The market is priced for the Federal Reserve to keep short term rates near zero for another 2-3 years, crimping returns for conservative savers.
- The Fed has also indicated it will accept an average inflation rate of 2.5% per year. [Inflation at this rate depreciates the value of fixed income instruments by 30% over a decade].
- We may be sounding like a broken record, but the key for bond investors continues to be proper duration management, and this will likely trump credit concerns.
The Week Ahead:
- Tuesday: Motor Vehicle Sales and Construction Spending
- Wednesday: ADP Employment Report
- Thursday: U.S. Factory Orders and China’s PMI Composite