Markets can’t catch a break. No sooner did the Eurozone’s leaders agree to new, more comprehensive steps to stabilize the peripheral countries’ sovereign credit situations than the US debt ceiling controversy looked headed for catastrophe. No sooner did Congressional leaders reach an agreement with the White House to avoid default than we started receiving a string of very disappointing reports on the outlook for the US economy. And now it’s starting to look like investors are demanding higher yields on Spanish and Italian government bonds, so we may be back at square one.
But this week’s sharp decline in stock prices and interest rates looks like an over reaction. The most telling observation, in my view, is the yield on two-year Treasury Notes, which closed Thursday at 0.25%., the lowest level on record. Such a low rate would only be consistent with the belief that there is no chance that the US economy will recover enough over the next two years to lead the Federal Reserve to raise short-term interest rates. It is certainly possible, perhaps even likely, that things will turn out that way, but it is not a sure thing. So, while recent week’s economic news should have resulted in lower stock prices and interest rates, the dramatic sell-off looks to me like an over-reaction.
So even in light of a cloudier economic outlook we’re not ready to throw in the towel on our basically constructive outlook on equities. The Barclays Wealth Tactical Asset Allocation Committee, comprised of our investment strategists and portfolio managers from around the globe, have been continuously debating the range of fundamental and technical data the market is presenting, right through today, in formulating our advice to clients. The result is that we still believe equities are likely to produce better risk-adjusted returns than cash, bonds or alternatives over the next few quarters, provided the following conditions continue to prevail.
1. The global economic recovery continues to progress, however haltingly,
2. Labor costs remain under control,
3. Central banks keep interest rates low supporting price-earnings multiples, and
4. Governments remain reasonably friendly to businesses.
The news we’ve received over the past few weeks has shed new light on all of these conditions: some positive and some negative. The net effect is to leave us still optimistic about equities, but much more cautiously so.
A Double Dip?
On the negative side, the economic news in the US has been very disappointing. For a few weeks it was possible to dismiss some of the weak statistics as “ancient history.” No jobs growth in June? Employment is a lagging indicator. Weak second quarter GDP growth, a sharp downward revision to previous growth estimates? The recession ended two years ago, and we already knew the first half was bad for a collection of temporary reasons.
But Monday’s announcement that the Institute for Sales Management’s Purchasing Managers’ Index (“PMI”) had unexpectedly declined to 50.9% cannot be dismissed. And Tuesday’s news that personal consumption expenditures had decreased in June was troubling because consumer spending usually only declines when the economy is actually in a severe recession. Perhaps the first half of the year was actually worse than “weak.” Unlike the other statistical reports of the week, Friday’s jobs report was not worse than expected, but expectations were so modest that it’s hard to take 117,000 net new jobs as good news.
The PMI release was particularly troubling. It is one of the more reliable forward-looking economic indicators we get each month. A number above 50% is taken to indicate that the economy is growing; a number below 50% that the economy is contracting. This statistic had been declining for several months, but, again, it was possible to dismiss the trend by observing that the decrease was from very high levels and that the statistic was still well above 50%. That refuge is no longer available. It is, however, too soon to panic about a “double-dip” recession. The PMI is, after all, still above 50%. And although it is one of the better indicators of future economic growth, it is far from perfect: to paraphrase Paul Samuelson, the PMI has predicted 13 of the last seven recessions.
Whether or not US economic growth actually turns negative over the next few quarters remains to be seen. But the data we have been getting, particularly the sharp downward revision of previous quarters’ GDP growth estimates does raise the likelihood that we are at the beginning of a prolonged period of weak economic growth, elevated unemployment and extremely low interest rates: a “lost decade”. Growth has been even slower than we thought it was, unemployment remains high, short-term interest rates are already at zero, and additional doses of fiscal stimulus are out of the question. And the situation is similar throughout the developed world. Indeed, the recent pattern of economic performance around the developed world bears an uncanny resemblance to what happened to Japan starting 15 years ago.
The Upside of Weakness
Evidence of profound and persistent economic weakness sheds light on the outlook for the labor market and for central bank policy.
Unit labor costs are unlikely to increase substantially any time soon. Before the revision of the GDP statistics, economists had been perplexed by how slowly employment was increasing; given the rate at which the economy was growing, we should have been seeing more jobs being created. This anomaly raised concerns that the unemployment rate might surprise us at any time by starting to decline quickly leading to wage inflation. Now it turns out there was no anomaly. The recession was worse than we thought it had been, so unemployment is not higher than it “should” be, given the level of economic activity, and there is little likelihood that labor costs will start rising rapidly any time soon.
The revision of recent economic history and the increasingly clouded outlook mean that central banks, especially the Federal Reserve, are likely to keep short-term interest rates close to 0% for many, many months, quarters, and, possibly, years to come. All else held equal, lower interest rates should lead to higher price-earnings multiples in the stock market, and, if earnings remain strong, higher stock prices.
Can profits keep growing?
Will all else be held equal? In particular, can investors anticipate continued strong corporate earnings in an environment in which economic growth remains sluggish? Yes, possibly, as long as profits continue growing faster than GDP. In light of recent revisions we now know that, although the economy has yet to recover fully from the great recession, profit’s share of national income has more than fully recovered and is now at an all-time high.
I’m not aware of any economic law that caps this ratio, but the juxtaposition of persistently high unemployment and record-breaking corporate earnings could lead to profit-unfriendly political developments. So, from the point of view of stockholders, it is encouraging that the last few weeks have shed positive light on the fourth condition for continued favorable stock market performance. US and euro area leaders have decided to deal with their fiscal problems in ways that impose minimal costs to investors. To be sure, European banks will have to realize some losses on Greek bonds under the agreement reached on July 21, but the “hit” turned out to be much smaller than it might have been. And in the US, while we can’t rule out some increase in future tax rates on corporate earnings or individuals’ investment income, most of the pain of fiscal adjustment will be borne by the beneficiaries of government spending.
The risk of a double-dip has increased, but another recession is still not, in our view, the most likely near-term scenario. In light of this expectation and in the wake of what I consider a disproportionate decline in stock prices and interest rates, I continue to recommend that investors hold more developed market equities and fewer bonds than they usually do.
Still, a few weeks ago I was very confident that the economic recovery would continue. I still think it will and want to hold an equity-heavy portfolio to benefit from continued strong corporate profit growth. The last few weeks’ bad economic news hasn’t changed either my basic opinion about the economy or my investment advice. But I have to say that my level of conviction in this regard is much diminished.
Aaron Gurwitz - Chief Investment Officer
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