Equity Investment Outlook - April 2015
In early 2015 global financial markets continued to be buoyed by a combination of low interest rates, central bank liquidity and positive, albeit modest, economic growth. For some time we have been talking about the "Goldilocks" backdrop of slow growth, low inflation and low interest rates that has been very rewarding for financial assets. In general, our assessment is that the U.S. economy is well positioned to deliver several more years of reasonable, low inflation growth paced by a stronger consumer, a stronger dollar and weak commodity prices. Our expectation is that this outlook will prove to be supportive of equity markets over the next 12-24 months; however, we note that near-term, a stronger dollar coupled with sharply lower earnings for energy companies could lead to several quarters of lower earnings for the S&P 500 Index (S&P 500). The companies most likely to show near-term earnings weakness will obviously be those U.S. companies with large non-U.S. dollar revenues, as well as energy companies. It is possible that U.S. equities will react negatively to near-term earnings softness, but looking out to the back half of 2015 and 2016, we would expect further strengthening in the consumer sector of the U.S. economy to restore both earnings growth and investor confidence in the resiliency of corporate profits and the economic recovery.
Plunging energy prices and a sharply stronger dollar have dominated the news so far in 2015. Both developments should help support U.S. consumer spending and contribute to keeping inflation and interest rates low. There is a near-term downside, however, to both lower energy prices and a stronger dollar leading some observers to take a more cautious stance on equities. This bearish view is predicated on the fact that the oil and gas industry in the U.S. has been responsible for a disproportionate share of U.S. employment and capital spending growth over the past three to four years. Now, the collapse in oil and gas prices over the past six to nine months is leading to a sharp contraction in exploration and development in every major energy-producing region in the U.S. This is leading to layoffs and an average 41% reduction in capital spending by oil companies. Our more constructive view is that while these cuts will dampen economic prospects in certain parts of the country, the U.S. economy overall should benefit from lower energy prices. Furthermore, if the dust settles in 2016-17, we think oil and gas prices will rebound from current levels and the U.S. energy sector will see renewed growth. Our best guess is that prices will rebound to a "new normal" level, down materially from the $90-$110 level that persisted in the 2011-2014 time period. The simple fact is that the world will most likely need new energy supplies over the next five to ten years. At these new normal levels, oil and gas prices should prove high enough for U.S. producers to resume increased drilling activity leading to production growth; but they should not stress the consumer and arrest the economic recovery.
The other issue that continues to make headlines is the ongoing obsession the financial markets have with the timing and magnitude of the Federal Reserve’s (the Fed’s) rate hike. As with any issue, there are bulls and bears. The bears would argue that the current bull market in both stocks and bonds will come to an end with the first rise in the fed funds rate. Some bears would go even further and say that there is a risk that the Fed might both push the stock market into a major bear market and drive the broader economy into recession similar to what happened when the Fed tightened prematurely in 1937, however, after the initial sell-off, the markets actually did quite well in the years that followed. Our sense is that the current Fed is highly attuned to the risk of tightening too soon and too much. With inflation still low, the dollar strong, labor participation rates still low and housing starts far below historical levels, we think the Fed is unlikely to aggressively tighten any time soon. Rather, we expect the Fed may begin tightening later this year with very small increases at first. These first few rate increases will represent a measured attempt to restore rates to more normal levels without slowing the economy. If this proves to be the case, we think that we may see some short-term volatility in equity and fixed income markets, but the stock market is likely to shrug off the initial rate increases when they eventually do come.
The timing and pace of Fed tightening will ultimately be determined by the strength of the U.S. economy and inflationary pressures. This brings us back to a focus on evaluating the fundamentals supporting continued growth in the U.S. In the U.S. consumer spending is responsible for close to 70% of gross domestic product (GDP) and hence plays a disproportionate role in determining the health and rate of growth of the economy. As we look over the past six years, there is much to be happy about as it relates to the U.S. consumer. In March 2009, the U.S. unemployment rate stood at 8.7% on its way to 10.0% later in the year. Today, the unemployment rate is 5.5% and is trending lower (Figure 1). There are also indications that Americans are starting to re-enter the labor force, which should drive the labor participation rate higher from the current low of 62.8%. In a related development, we’re seeing close to 4% growth in disposable incomes. Additionally, some of the largest retailers are announcing hourly wage increases and it is likely that other major employers of hourly workers will follow suit.
Source: U.S. Bureau of Labor Statistics; Labor Force Statistics from the Current Population Survey (Data end date: 3/31/15)
As the job picture has improved dramatically, the consumer has also been able to borrow more. Last year consumer credit balances grew by 7% as compared to a decline of almost 4% in the recession of 2009. All in all, outstanding consumer credit balances (excluding mortgage debt) have grown by approximately 30% since the end of 2009. In fact, the decline in mortgage debt has allowed the consumer to borrow more for other activities, including education and consumption, without increasing his or her overall liabilities. And, of course, this credit is obtained by consumers at historically low interest rates.
The U.S. consumer is also seeing significant improvement on the asset side of the ledger. Home prices and stock prices have rebounded off of their recessionary lows (Figure 2). To put all of this in simple terms: the U.S. consumer is enjoying a much stronger job market, has access to credit, has a stronger personal balance sheet (thanks to recovery in housing and stock markets) and is benefitting from lower energy and import prices. It is no wonder that consumer confidence has rebounded and remains at high levels.
Source: United States Census Bureau (Data end date: 2/28/15)
All of these positive trends for the consumer are happening against a benign inflationary backdrop. Wage inflation is low, at least for now. The velocity of money (as measured by M2), is also at the lowest level since the measurement began in late 1950s. Low velocity is associated with a non-inflationary environment. Recent increases in the value of the dollar and decreases in oil prices are also generally viewed as non-inflationary.
It is important to ask what could bring this happy state of affairs to an end. Over the past six years, while the U.S. consumer was trying to delever, the U.S. government borrowed at a rate previously only seen during the world wars of the 20th century, leaving total U.S. debt to GDP at 102% compared to 64% at the start of 2008. Today, we are in uncharted waters with government debt high and interest rates extremely low. The Fed has purchased much of the debt that the U.S. government issued over the past few years as part of its Quantitative Easing (QE) programs. Regardless of who holds the debt, if interest rates were to move much higher and do so quickly, the interest expense burden on the U.S. government budget would rise materially, resulting in larger deficits. This could make it harder for the government to attract buyers of debt, which in turn could drive interest rates even higher. The resulting financial strain on government finances could lead to a credit crunch on both consumers and businesses. Tightening credit conditions and rising interest rates may also arise if markets perceive that the Fed is moving too slowly in the face of escalating wage rates. Finally, it is possible that further strength in the dollar in combination with slowing economic growth abroad could lead to such a severe deterioration in our trade balance that the economy could stall. We think this is an unlikely scenario given how small international trade is as a percent of U.S. GDP.
Shifting to the stock market, the S&P 500 is trading at the higher end of its historic valuation range measured across a variety of metrics. It’s trading at an ~18x price-to-earnings (P/E) ratio (vs. its 20-year average of ~19x and 10-year average of ~16x). Using the cyclically adjusted price-to-earnings ratio (CAPE), the market trades at 28x vs. a 17x long-term average. Adjusting, however, for the present unusually low interest rate environment and with the backdrop of benign economic conditions, the valuation of equities today appears more reasonable and actually could move even higher. Given that near-term interest rates are virtually at zero, the implied 5.5% equity earnings yield (the inverse of the current 18x P/E ratio) appears reasonably attractive. While this virtuous relationship between low interest rates and ever increasing equity valuations will probably not last forever, in an environment of continued slow growth and low inflation, interest rates are likely to rise only moderately and equity valuations may remain in the upper part of their historic range.
Taking all of this into account, we remain vigilant as to the ever-present threats to capital while at the same time continuing the search for unusually attractive investment opportunities. We recognize the uncertainties inherent in any economic or market forecast and we are not betting the farm on any particular economic view. We continue to seek misunderstood and undervalued businesses with good or improving fundamentals; one company at a time. This is what we do in all markets, whether bull or bear.
Past performance is no guarantee of future results.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Price-to-Earnings ratio is the ratio of the stock price to the trailing 12 months diluted EPS.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
This index reflects the reinvestment of dividends and/or interest income and is not available for investment.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
Velocity of Money is the ratio of nominal gross domestic product (GDP) to a measure of the money supply. It can be thought of as the rate of turnover in the money supply (the number of times one dollar is used to purchase final goods and services included in GDP).
M2 is a measure of money supply that includes cash and checking deposits (M1) as well as near money. “Near money” in M2 includes savings deposits, money market mutual funds and other time deposits, which are less liquid and not as suitable as exchange mediums but can be quickly converted into cash or checking deposits.
CAPE Ratio (also known as the Shiller Ratio): cyclically adjusted price-to-earnings ratio. The numerator of the CAPE is the real (inflation-adjusted) price level of the S&P 500 Index and the denominator is the moving average of the preceding 10 years of the S&P 500 Index’s real reported earnings, where the U.S. Consumer Price Index is used to adjust for inflation.
One cannot invest directly in an index.