Spring Forward – Fall’s Behind
Recently, many have remarked how the U.S. stock market has soared straight up from the end of Q3 2011. And viewed in that specific window… it has. Looked at from the bottom of the Q3 correction, the market has climbed nearly 30% in 6 months. Focus on this viewpoint has prompted comments along the lines of the following:
However, when observed with a longer perspective and the hindsight that the underpinnings of last fall’s correction proved to be meritless, the recent assent of the U.S. market seems much more moderate, a modest 8.5% over one year.
It is my assertion, that the recent run-up was just the correction of a misguided mistake made by emotionally fragile markets, and the subsequent resumption of a longer-term secular bull-recovery.
How the Markets Fared
Globally, equity markets steadily marched forward for much of the first quarter. A simple lack of bad news accompanied firming economic data to provide a stead wind at the back of stocks. Smaller names generally fared slightly better than those of larger companies, traditional growth categories provided marginally better returns than cyclically sensitive values stocks, and while foreign developed markets lagged those of the US, both were generally bested by international emerging markets. All in all however, returns were robust, with global equity indexes seeing gains in the tight range of 11%-15%.
The fixed income markets saw a broader dispersion in performance during the quarter. Higher quality bonds of longer maturities saw a pullback in value as interest rates climbed back up from record lows. Yields on the 10-Year and 30-Year U.S. Treasuries rose 33 and 45 basis points respectively leading to meaningful drops in bond prices at the long end of the market. As the global economic outlook continued to firm, risk spread continued to tighten (in the same way they did in Q4 2011). Bonds with deeper credit exposure, such as domestic high yield and emerging market debt, saw moderate gains in value during the period. Stuck in the middle with nominal returns were the aggregate indexes, which benefited somewhat from their credit exposure, offsetting losses to their government components.
By The Numbers:
Q1 marked the first drop in S&P 500 earnings in the 10 quarters since the beginning of the recovery. Although this is not unusual during an economic expansion (the 2001-2007 expansion had four such drops) it does mark a potential pause. The low hanging fruit may be off the tree. If earnings continue to rise as expected (S&P expects earnings in Q4 2012 to be 10.5% stronger than Q4 2011), a change in the makeup of where we have been finding earnings growth will have to develop. Margin improvement has been the major contributor in earnings growth until recently. In order for U.S. companies to continue to grow profits, it appears that increases in sales will begin to be the new driving force. And I suspect they will.
“Morning of the Top to Ya’!”
Where does top-line growth come from? Increases in sales can come from a multitude of places in today’s environment. Read on for the data that supports what I see as key contributors to this potential.
- As I have said all along, “It’s the emerging consumer, stupid!” U.S. multinationals are well positioned to take advantage of the reacceleration in emerging market economic growth. JPMorgan estimates that GDP for these developing nations will accelerate from 5% to nearly 6% by year’s end. This is crucial as these emerging economies continue to represent an increasingly important share of global consumption.
- Businesses continue to drive us forward. Both the Services and Manufacturing side of the ISM Report on Business® (formerly referred to as the Purchasing Managers Index) continue to show that we are in expansion mode. Manufacturing continues to improve, climbing to the 53.4 in March (a reading over 50 indicates expansion). The service side of the economy is growing even quicker, according to its March reading of 56. Strength in new orders from both sides of the report indicated that that this trend should continue into the near future. The reports are also indicating that the recent trend of increased hiring is going to continue as well.
- Increasing employment at home should provide a two pronged contribution to our domestic spending. Each 1% improvement in the employment rate means over 1.5 million workers added to the economy, with the ability to resume consuming. Further, strengthening employment has historically had a high correlation to a bolstering in consumer confidence for those who are already participating in the workforce. If the unemployment rate declines into the mid 7% range in between now and the election, the effects of the progress will be multiplied.
- In fact, improving sentiment is already well underway. Similar to the latest stock market rebound, consumers recovered quickly from their fear-state last fall when the predictions of a double-dip-recession proved to be unfounded. We recently detailed how Christmas 2011 was a resounding success. Now, confidence is challenging its highest levels since the 2008 crisis. This is, in no doubt, finally helped by housing prices which have leveled out over the last year and a half and in some markets have begun to turn upward. Also as we have previously commented, the average household’s financial statement continues to look outright rosy; with lower debt payments, record high credit scores and strong savings levels (~4%).
- Need more evidence than a strong Christmas? New auto sales have recently returned to their norms of 15 million units a year. Construction spending has risen a respectable 6% year over year, with 10% gains in the private sector helping to offset declines of 1% from government projects. We are clearly poised for a meaningful contribution to the recovery from a reinvigorated consumer if these trends continue.
I could go on and on, mentioning the recent growth in the money supply (and its velocity), increases in housing starts, record home affordability, etc. All signs would point to a continuation, if not an outright acceleration of the recovery. If these indicators hold, then top-line growth will materialize bringing bottom line earnings up with them. It is my PIERspective that they will.
If there is a potential stumbling block lying ahead in the road of global recovery, it’s that things could get too good, too fast. As the world continues to wake from its economic slumber, the scarcity of resources will be revealed in a way we have only glimpsed. How quickly 2007’s $150 per barrel price for oil faded from memory once the financial crisis hit in 2008. In 2007, material costs for essentials like copper and steel, let alone food, were weighing on many family’s already stretched budgets. Fast forward to 2012’s moderate economy and we already see signs that higher prices may be ahead. The Dow Jones U.S. Basic Materials Index was up over 9% in Q1 alone.
According to Engineering News-Record, even in this anemic environment, March’s Materials Cost Index rose 3.3% year-over-year. Steel was up almost 6%. Though these increased costs have yet to materially impact inflation readings like CPI, one wonders how much slack we have in the system before they appear. With the Federal Reserve’s bold commitment to keep interest rates near zero well into 2014, my concern is that our monetary policy makers will react too slowly if demand begins to outpace supply as quickly as it did in 2007. Since that time, the globe has added well over 100 million new consumers. A tipping point on prices may hit even more quickly this time around. How would the recovery react in the face of flash-flood-inflation? I suspect, not well.
“We’ve Come a Long Way, Maybe”
Now that my future inflation concerns have been stated once again, I believe we have a ways to go before it becomes an issue. The recovery in developing markets can likely sustain some headwinds from rising costs. Locally we may be a bit more sensitive, both literally and psychologically. Nonetheless, rising prices are still likely to mean rising profits, at least at their onset. As I stated before, in order to grow E, companies need to increase their top-line.
On the way to rising prices we can expect to enjoy accelerating economic conditions. Labor should continue to improve, as should asset prices. Houses are more affordable than they have ever been, and people are finally taking notice. Despite the recent 30% run, equities are still trading at a 20% discount to longer-term norms. In fact, even with record earnings in the S&P 500, we are still over 10% away from 2007’s prior peak in the market. It seems to me that the lowered expectations that seem to dominate the media these days create even more opportunity for upside surprise. For how long this phase of advancement will last remains the key question… in my PIERspective.