Market Insights: October 21, 2013
Economy: The can has been kicked…
- The Washington drama finally ended in the late hours last Wednesday night. However, the can, getting increasingly heavy, was kicked down the road, which is getting a bit rockier. It will probably be “déjà vu all over again” as we close out 2013 and move into the first part of next year. (Or, perhaps we will all be pleasantly surprised by the interim budget negotiations.)
- Why are U.S. companies sitting on so much cash? Certainly one reason may be this continuing fiscal gridlock by our policy-makers in Washington. It does not inspire much confidence within the business community. What would our GDP growth rate be and where would the unemployment rate stand if there were a higher degree of confidence about the future? A recent report found that America’s budget fights have cost more than 2 million jobs and slowed annual economic growth by one percentage point of GDP since 2010 [Macroeconomic Advisers].
- The cumulative effect of several weeks of intense uncertainty combined with the actual economic impact of the government shutdown will likely exact some level of economic toll on the economy in the fourth quarter.
- The NAHB Housing Market index dropped in October, which probably reflects the delayed effect of rising mortgage rates more than angst over the Washington drama. Mortgage applications for new purchases have dipped below the year-ago level, so home sales may slow down in the coming months.
- Despite these short term hits, we have not become negative on the 2014 outlook. The outlook for inflation remains subdued for the near term, despite easy money and deficit spending. Clients ask us why this is so. The simple answer is that economic growth, while steady, is slow, and with slow growth, imbalances like inflation are not easily developed. Significant inflation requires rising labor costs and the unemployment statistics make it clear that demand for labor is not robust currently.
- That said, the Fed actually wants inflation to go higher, rather than lower. So at some point, we will see a pick-up, even though it is not likely in the near term. And the rate of acceleration in the labor market has moved up recently [San Francisco Fed’s recent report]. So perhaps the seeds are sown, though they make take more time to germinate.
- Slow growth also makes it more likely that the economic recovery will actually continue longer, even though we are now a full 4+ years into the recovery cycle.
- Johnson Redbook chain store sales for the first of October are +3.2% from one year ago.
- The international economic news is much the same. Despite a few short term hits, the trend of emergence from recession seems intact.
- Auto sales numbers for September in European markets have been released. For the Euro-zone, new registrations are up almost 6% over one year ago. We view this as further confirmation that the European freeze is thawing and the recession is ending.
- The UK jobless rate declined significantly in September, continuing an 11-month trend. And the Euro-zone leading indicators have been in positive territory for 4 straight months and are ahead of their levels from more than 2-1/2 years ago.
- The auto sales numbers from China are up more than 20% from a year ago. This does not look like a statistic from an economy making a hard landing.
Equities Outlook: The Big Idea…
- The market responded to all the fiscal uncertainty in a traditional way: “Buy on the rumor and sell on the news.” Ahead of the resolution, the market was up big. The market leveled out on Thursday, following the resolution, and the Dow average actually closed slightly down for the day.
- The market (S&P 500) is presently trading at a forward earnings multiple of about 14.5. That is not a level that causes one to fear excessive valuation. Neither is it under-valued. As we’ve written in the past few weeks, a target for the S&P 500 by the end of 2014 in the 1850 – 2000 range is realistic with projected earnings growth for U.S. companies.
- We are solidly into the season for reporting earnings. A little more than one-half of the companies reporting are beating estimates. That percentage is not as good as the long-term average (which is closer to 65%).
- The international opportunities continue to look interesting to us. While GDP numbers for Q4 in the U.S. are generally being trimmed, the reverse is happening for the UK, China, the Euro-zone, and Japan.
- Most of the questions we get from clients deal with the short term noise in the financial media. More important is the Big Idea for the intermediate term: investors must establish the right policy parameters for their portfolio around their personal goals and maintain some consistency.
- For most people, a consistent investment policy means some combination of bonds and equities. At the margin, equities look better to us than bonds for the intermediate term. But they will likely experience volatility, so don’t throw out your bonds altogether. They still present some opportunities, as we will discuss below.
- We remain in an environment of accommodation by the Fed, which is almost always good for equities. Every month the Fed delays tapering has been estimated to be equivalent to a 10 basis point cut in the Fed Funds rate [David Rosenberg of Gluskin-Shelf & Associates].
The Fed and Fixed Income Markets: Opportunities remain nonetheless…
- We got a mini-rally in government bonds last week, likely on fears that the near-term effect of the shutdown and fiscal uncertainty will take some short-term toll on economic growth. The 10-year Treasury traded below 2.60%, which has not happened in a few weeks.
- It is a far cry from the upheaval in the short-term Treasury market earlier in the week, when the one month T-bill traded as high as a yield of 39 basis points, higher than at any time since 2008.
- Despite the passage (postponement?) of the crisis, we are not enthusiastic about jumping on any bond bandwagon here. Bonds do not look attractive, even in a relatively tame inflation environment that might persist for the next two years.
- The kicking of the fiscal can down the road certainly makes it even more likely that the Fed will not rush to taper the QE program. It could be next year before we see the first move.
- Meanwhile, the market for municipal bonds remains interesting. Several highly publicized problems (Detroit and Puerto Rico), along with the prospect of Fed tapering has created some redemption pressure on municipal bond funds. That means at the margin, the ratio of sellers to buyers has increased, putting downward pressure on prices. For us, that can be an opportunity to make attractive additions to clients’ portfolios of individual municipal bonds.
The Week Ahead: Foreign and private sources…
Monday: Existing home sales
Tuesday: September payroll report
Thursday: JOLTS Report, New home sales
Friday: Durable Goods Orders, Consumer Sentiment