If you prefer a PDF version of the below report, download that file HERE.
Last Quarter Review: Remember Nobel Laureate Paul Samuelson’s quip that the Stock Market predicts 9 of the past 5 recessions? Well global stock markets predicted that Britain would REMAIN in the European Union with a run up in markets before the referendum…and then ‘Brexit’ happened (the British vote to leave the EU). While Brexit was a large focus throughout the quarter with corresponding volatility, the market and US economy has been grinding forward positively. Long term focus on goals can temper the fear of headlines including the pending US presidential election and associated campaign activity.
Investment & Economic Summary (source – Moody’s Analytics): Economic data is not robust and is mixed with both positive and negative indicators, but overall the data favor Bulls (optimists) over Bears (pessimists). The FED is holding off on increasing the Fed Funds Rate because of employment numbers and Brexit. Economic details are:
- Payroll employment increased by only 38,000 in May, while the gains for March and April were revised lower, from 208,000 to 186,000 in March and 160,000 to 123,000 in April. The three-month average dropped to 127,000.
- The Chicago Fed National Activity Index wiped out much of its gain in the prior month by falling from 0.05 in April to -0.51 in May. The CFNAI reading has fallen below its neutral threshold for three of the past four months. Moreover, growth remains below its historical trend for the ninth consecutive month, according to the three-month moving average, which slumped to its lowest level since late 2012.
- This was the BEA’s third estimate of GDP for the first quarter. It reported that the economy expanded 1.1% on an annualized basis, after rising 1.4% in the prior quarter. This was the weakest growth in a year.
- The ISM nonmanufacturing composite index fell 2.8 points to 52.9 in May. This more than reversed the increase over the prior two months and is the fifth decline in the past six months.Though the worst likely has passed for manufacturing, a quick turnaround is unlikely. The ISM manufacturing index is showing signs of improvement, and rose from 51.3 in May to 53.2 in June (values above 50 are considered expansionary).
- Industrial production fell 0.4% in May. This is the third decline in the last four months. More important, production has lost 3% since peaking in November 2014. With lower production and higher employment, productivity declines (see above table)
- Consumer confidence gained 5.6 points to 98 after a slight downward revision in the May index. The three-month moving average rebounded as a result, erasing the May decrease. Despite month-to-month fluctuations, the moving average is down only 0.6 point from January.
- The probability the U.S. will be in recession in six months rose to 20% in May but remains low. It will naturally increase as the expansion ages and we bump into capacity constraints. However, we believe this expansion has room to run; we have normally adopted a recession as our baseline when the probability of recession hits 60%.
Expectations – next quarter: After the surprising reduction in earnings in Q4, it looks like the bottom in earnings has occurred with Q4. The table nearby shows that Qr.1/Qr.4 Earnings have increased 3.95%. The headline number of Yr/Yr earnings of -7.13% is troubling but the Qr/Qr data suggests upward earnings momentum. Note as well that earnings are improving going forward according to S&P analysts’ predictions. If this happens, we may exit the nearly 2 year trading range in the stock market. We are hopeful.
Following BREXIT, Mastrapasqua Asset Management, Inc. provided wise comments:
The lower [interest] rate structure raises the floor under the equity market. Moreover, the U.S. stock and bond markets have become even more attractive. Rates in the U.S. are higher than in Europe and Japan. [US Stock] Dividend yields are well above the 10-year Treasury yield, and the recent selloff has created even more competing values. In addition, the U.S. markets are deep, liquid, and remain the safe haven. In periods of uncertainty, fund flows are likely to move to the U.S. with the expectation of the dollar remaining strong. Higher yields and higher currency values generate two sources of an investment return. To the extent that the dollar strengthens, it will again become a head wind for multinational corporations (revenue and earnings conversion), and continue to weigh on U.S. exports. The Federal Reserve and other major central banks are likely to increase the tailwinds of monetary accommodation.
Exchange rates are likely to be volatile over the short-term, but the economic and business impact of a stronger dollar could be far less than what occurred last year. Most importantly, the Brexit vote and the fallout in other countries in the coming weeks should be viewed as a political event. Although these events are important, they are not economic “game changers”. To the extent that political volatility impacts economic policy, it could generate results contrary to current expectation.
Our take-away from the above is that US Equity Markets are positively impacted by:
- FED interest rate policy
- The difference in yield between US Equities and Treasuries
- International fiscal conditions show the US as an ever stronger economy
- Brexit is not, and won’t be, a significant factor in US trade (in fact there are opportunities with strengthened relations with the UK)
From the Wall Street Journal:
Mario Draghi (4/21/16) wants you to know that he’s frustrated. Really frustrated. With no new monetary measures to announce, the European Central Bank president instead unleashed some strong words on the ECB’s many critics.
“With rare exceptions, our monetary policy has been the only policy in the last four years to support growth,” he said in response to a question about threats to the economy. It was an unusually blunt criticism of other European leaders, even from a central banker who takes every opportunity to plead for supply-side reforms to augment his bond purchases and ultra-low interest rates.
The source of Mr. Draghi’s angst is the failure of Europe’s political class to implement any serious supply-side reforms. The central banker thought he was making a grand bargain in which he would deliver low borrowing costs and governments would reform labor markets and entitlements and cut taxes. He should have gotten that in writing, because politicians have used the relief of low interests rates as an excuse not to do reforms.
For Europe to grow faster, the political class will eventually have to stop looking to the ECB as the growth engine of first and last resort.
Perhaps BREXIT will wake Europe up. Frankly, the same can be said of the US political class for our slowest recovery after a recession has the same origin of poor fiscal policy. Employment results indicate policy direction with GDP growth analogous to employment growth. This link shows a current poor recovery and vastly different from all other recoveries since WW II.
This may sound contradictory, however, our point is that regardless of the relative strength of the US from a global perspective, this recovery could be so much better. Therefore, this remains a risk going forward if global economic weakness continues to be present.
From Bob Doll, Chief Strategist of Nuveen Investments:
“We Favor Equities, but Anticipate Choppiness”
Investors are now left to wonder whether the recent increase in equity prices reflects real underlying improvements in the economy and earnings picture, or whether it is a temporary mirage. We lean more toward the former interpretation. The global economy has been resilient to shocks over the past several years and we believe it is improving. Key metrics include U.S. consumer spending, global manufacturing and global trade levels. To be sure, the global economy remains fragile and vulnerable to some sort of negative shock, but we think the odds are more likely than not that world growth should accelerate modestly.
As we discussed earlier, several near-term risks could damage equity markets. However, we think investors will grow more confident in the state of the global economy and should react positively to improvements in earnings growth over the next few quarters. There is little doubt that markets will remain choppy, and equity prices won’t move in a straight line. But one year from now, we believe equity markets will be in better shape than today, and we think stocks will outperform bonds and cash.
In a recent Barron’s article, a Merrill Lynch technical analyst Stephen Suttmeier noted “It has been more than 380 days since the S&P 500 index last hit a record high… Hitting a new high following a pause of 300 days or more is a rare occurrence in the market – it has happened just 23 times since 1929… Yet, when it has occurred… the S&P 500 has gained 15.6% on average during the year following a protracted interlude…”
Investor negativity may not match reality. The research firm Cornerstone Macro recently said it best: “It’s not often that you can say that oil prices are up over 30% year to date, and investors are worried about deflation. It’s not often you can say that the market is [close to] an all-time high, yet investors are worried about growth. It’s not often you can say ‘risk-on’ is working and yet bullish sentiment is sitting near all-time lows. It’s not often you can say the VIX is at 13, yet investor uncertainty is at modern highs.”
Clearly, there is a disconnect between the data and investor attitudes.
We are optimists for the US market and pessimistic for Europe, Japan and China. If that is correct, money will flow to the US for reasons mentioned above. We have had our trading range and every trading range ends sometime. We think the market will burst on the upside in the second half of the year if earnings come through…but not likely until September or October.
2016 is our 30th year helping clients manage their wealth and planning their future. Thank you for being a part of that!