Federal Reserve Supports Marietta's Positive Outlook for U.S. Economy and Stock Market

On March 21, the Federal Reserve Open Market Committee reiterated its positive year-end forecast for U.S. economic growth in 2014 and 2015. In a subsequent press conference, Fed Chair Janet Yellen stated that weak U.S. economic data in January and February was due primarily to bad weather and would pick up in coming months. She emphasized that "the Committee's views are largely unchanged" since December and confirmed the Fed's prior prediction of 2.8-3.0% GDP growth and 1.5-1.6% inflation in 2014. With this promising outlook, the Fed expects to continue its tapering policy to completion in September. It will proceed to raise its base short-term interest rate after a pause if inflation and employment data continue favorably.

Marietta's January 3 Outlook emphasized the importance of economic acceleration and corporate profit growth in extending the 5-year bull market through 2014. The 29.6% surge in the S&P 500 index in 2013 was driven in part by a 10.8% increase in S&P 500 corporate earnings but even more by an increase in the market's P/E valuation. This "multiple expansion" has resulted in a rise in the Index's current P/E ratio on trailing 12-month earnings to 16.5, which is above the last 10-year average of 14.7 We consider the market to be fully valued rather than overvalued, but we think a further advance should be fueled by earnings growth rather than multiple expansion. Hence, our bullish view relies on our favorable 2014 forecast of 3.0% GDP growth and a rise of 7-9% in corporate earnings.

We are encouraged by the 4th quarter corporate earnings reports released during the 1st quarter. According to Howard Silverblatt at Standard & Poor's, 64% of S&P 500 companies reported earnings above Wall Street estimates and an additional 11% met expectations. He also indicates that company research analysts are currently estimating an increase of 12.1% in aggregate operating profits for all of 2014. Assuming the S&P 500's P/E valuation remains constant through 2014, this increase in profits would reward investors with another year of double-digit returns. We think this scenario is reasonable because the market's valuation multiple is unlikely to contract as long as the expected return on money-market funds and bond alternatives remain unattractive.

A concern for some investors is that the Fed's statement is actually negative for the stock market because it hastens the date of an increase in historically low 0-0.25% short-term interest rates. We are not persuaded. The Fed has clearly indicated that it will not raise rates until it is convinced that economic growth has achieved healthy, sustainable growth, which in turn will increase investor confidence in further profit growth. Our view is that investors will not become excessively alarmed as long as inflation and interest rates remain below long-term norms of 2% and 4% respectively.

IMF Forecasts Accelerating Global Economic Growth in 2014 and 2015

On January 21, the International Monetary Fund (IMF) issued a positive update on its World Economic Outlook. In a press conference, Olivier Blanchard (Economic Counsellor and Director of the Research Department) stated the report had three main messages:

• The global economic recovery is strengthening, with accelerating growth in both the developed and emerging economies (see infographic below):

Source: IMF World Economic Outlook (WEO) Update: Is the Tide Rising?, January 2014 

• This increase in growth was anticipated. The drag from fiscal consolidation is diminishing; the financial system is slowly healing; uncertainty is decreasing.
• The economic recovery remains relatively weak and uneven, and risks are evident.

For the U.S., the IMF projects a rise in GDP from 1.9% in 2013 to 2.8% in 2014. Blanchard commented:

“U.S. growth appears to us to be increasingly solid. Private demand is strong. As a result of the December budget agreement, fiscal consolidation, which weighted on growth negatively in 2013, will be more limited in 2014.”

The IMF update is good news to global stock market investors. We pointed out in our October 1 and January 1 Outlooks that the world's stock markets rose every year this century when global GDP growth accelerated. We note that Marietta's forecast for 2014 global growth is 4.1% and for U.S. growth is 3.0%, and thus we think the IMF is still too conservative and will raise further estimates as the year progresses.

U.S. Economic Outlook

            Prospects for the U.S. economy in 2013 are brightening …unless the politicians permit the economy to go over the “fiscal cliff” (the combination of government tax increases and spending cuts scheduled to take effect at the end of the year unless the Congress and the Administration take preventive action).  We do not expect this to happen, and there may well be a significant stock market gain if a political compromise removes the danger.     

            In our last two Outlooks, we highlighted the progress underway in the multiyear restoration of consumer confidence and spending, the housing market, and the banking industry.  We emphasized that each of these three key sectors was crippled during the 2008-09 recession.  From the outset of the recovery, we referred to them as “structural impediments to growth,” which would take years to heal fully despite pro-growth fiscal and monetary policies from Washington.  Our point was that whereas they restrained recovery over the past three years, we now expect each to support growth in 2013. 

            A number of recent reports and developments lead us to conclude that the U.S. economy is already strengthening:

·                Consumer confidence is at a 5-year high.

·                Consumer spending, bolstered by 2 consecutive upbeat employment reports, is resulting in better than expected retail sales. 

·                A retreat in gasoline prices further supports consumer confidence and spending.

·                The housing market has clearly bottomed in response to rising demand, reduced foreclosure pressure, and record low mortgage rates. 

·                Bank profits are up, balance sheets are much stronger, and loans are increasing.

·                The Federal Reserve has stated unambiguously its top-priority is economic growth and has promised to keep interest rates low until recovery is assured, which many expect to be 2014 at the earliest.

·                U.S. exports may well benefit from the continuing initiatives taken by central banks around the world to stimulate growth.  International Strategy and Investment (ISI), a highly respected economics research firm, has counted 296 easing steps by central banks over the past 14 months.

The mostly positive economic news of the past 1 1/2 months supports our above-consensus October 1 forecast of 2.0-2.5% GDP growth in 2013.  This would not qualify as healthy growth, but nevertheless represents an improvement over 2012.                    

Hurricane Sandy has inflicted significant human hardship and misery, and has caused near-term economic disruption.  However, in the long-term we expect the recovery efforts and the resilience of the people and businesses affected by this tragedy to rebuild, thus mitigating the overall economic impact.

The major threat to our generally favorable outlook for continued economic expansion is the “fiscal cliff.”  We continue to think there will be a political compromise because neither party can afford the risk of being blamed for an avoidable recession.  We are encouraged that leaders of both political parties have expressed a willingness to compromise.  Nevertheless, we do not underestimate the impact of partisan politics and recommend that investors maintain vigilance and flexibility.

We encourage our clients to contact us and let us know their views.

Kathy Klein Presents Positive Case for Global Equities

On January 31, Marietta portfolio manager Kathy Klein presented an optimistic outlook for global stock markets to about 90 retirement professionals attending a luncheon sponsored by the Greater Milwaukee Employee Benefits Council.

Kathy opened with a brief review of the challenging market conditions of 2011, when a relentless flow of negative news events convinced many investors that Europe and the U.S. were headed for a double-dip recession. Most of the world’s stock markets declined: the All Country World Index excluding the U.S. slumped 13.7% and the leading emerging-economy markets crumbled more than 18%. The U.S. faired better, not so much because the U.S. economy was attractive, but rather because it was viewed as a safe haven in troubled times. Within the S&P 500 Index, the defensive industry sectors of utilities, consumer staples, and health care were the major winners, and the biggest losers were the economy-sensitive, cyclical industrials, materials, and financials.

Kathy then pointed out that conditions in early 2012 have improved dramatically. The U.S. economy is accelerating, the European policy-makers seem determined to deal effectively with their sovereign-debt crisis, and declining inflation in the emerging economies is permitting their central banks to adopt pro-growth initiatives. Market trends have correspondingly reversed. Global stock markets, led by the emerging-economies, have surged. Within the S&P 500, last year’s leading industry sectors are now the worst performers and vice versa.

The obvious question posed by this reversal is: can the positive market trends of January extend through 2012? Here, Kathy emphasized the importance of the current synchronized global accommodative policies of central banks. It was just such a synchronized global stimulus that was the most important catalyst in lifting the global economy out of the recession of 2008-09 and triggering a new bull market.

Kathy also noted that in many leading global markets the fundamentals and technicals are positive. Time did not permit her to explore these conditions in all of these markets, so she limited her discussion to the U.S. market. In particular, she identified nine indicators which historically have been associated with bull markets. These included GDP growth, strong corporate balance sheets, compelling valuations, subdued inflation, low interest rates, an accommodating Fed, and large cash reserves.

A very interesting and relevant observation made by Kathy was that sluggish GDP growth of 2-3% in the U.S. should not necessarily lead investors to conclude that prospects for U.S. stocks are at best modest. To the contrary, since 1960 periods of weak-to-moderate growth have provided the best S&P 500 gains.

Key to Kathy’s positive case for the U.S. market is continuing profit growth coupled with a very attractive valuation. A high-single digit profit gain in 2012 by S&P 500 stocks in combination with P/E multiple expansion to a non-recession level could produce a solid, double-digit advance for this benchmark index. P/E valuations for the international markets are even lower, and the prospect of a very considerable market advance in the emerging markets is pronounced.

Kathy pointed out that negative news events could again upset the positive case, but concluded with Marietta’s 2012 upbeat investment recommendations:

1.       Be open to the positive case for equities

2.       Take a longer-term view (avoid excessive responses to headline news)

3.       Adopt a global perspective (take advantage of international opportunities)

4.       Watch for risk-on, risk-off decoupling

5.       Beware of macro investing (watch the policy makers)

6.       Track closely the fundamental progress of your securities

Promising News from China

On January 17, China announced that its economy expanded 8.9% year over year in the 4^th quarter. The news triggered a 4.9% jump in the Shanghai stock market, which was the largest single session gain since October 2009. On this news, the U.S., European and other global markets also rose.

The 8.9% GDP growth is the slowest advance in 10 quarters and is attributed to slowing export demand and a weakening property market. This increases the pressure on Premier Wen Jiabao to ease monetary policy, which would be viewed by investors as a strong positive for the Chinese stock market. On the other hand, the 8.9% was above the 8.7% median estimate of a consensus of economists, and well above the 8% that policy makers consider necessary. This supports the argument that the Chinese economy will experience a “soft landing,” which would also be very positive for the Chinese and other global stock markets.

A “soft-landing” in China and other leading economies is very important to the positive economic and market forecast presented in our January 3 Outlook. Emerging economies now account for 50% of the world’s GDP and approximately 70% of GDP growth. Healthy and sustainable growth in the Chinese economy is thus necessary for a global economic expansion requisite to support a resurgence of international markets. The news is very promising, but not decisive. 

Global Economic Revisions

The sharp decline in global stock markets last week was in large part attributed by the financial media to economic warnings issued by the Federal Reserve and the International Monetary Fund (IMF). The reports spawned a rash of recession forecasts as markets tumbled. A closer look at the press releases of these institutions, however, reveals a far less ominous outlook of continued albeit more modest growth. 

Financial markets were well aware before last week that the U.S. and European economies were weakening and that there was a rising risk of further deterioration. It was the Fed’s language that startled investors. Their September 21 policy statement asserted that “there are significant downside risks to the economic outlook, including strains in global financial markets. ”This was a sterner warning than the Fed’s August 9 alert that “downside risks to the economic outlook have increased.” 

Investors evidently overlooked the positive growth forecast in the Fed’s statement: “The Committee continues to expect some pickup in the pace of recovery over coming quarters” and anticipates a gradual reduction in unemployment. Indeed, three members of the ten-member Committee believed the economy was not in imminent peril and voted against the Fed’s new “operation twist” policy on the grounds that they “did not support additional accommodation at this time.” 

In its semi-annual global economic report released last week, the IMF alarmed investors with the opening statement: “The global economy is in a dangerous new phase. Global activity has weakened and become even more uneven, confidence has fallen sharply recently, and downside risks are growing.” In the introduction, Executive Counsellor Olivier Blanchard pointed out that “fear of the unknown is high” and concluded: “In light of the weak baseline and high downside risks, strong policy action is of the essence.” 

The actual growth projections in the IMF forecast are more encouraging. Global GDP growth is expected to be 4.0% in 2011 with an additional 4.0% in 2012. The U.S. will avoid recession with 1.5% growth in 2011 and 1.8% growth in 2012. The Euro Area is projected to slip but remain positive: 1.6% growth this year will slide to 1.1% in 2012. The emerging and developing economies will continue to drive global growth with gains of 6.4% in 2011 and 6.1% in 2012. China and India will maintain their torrid pace with 2012 gains of 9.0% and 7.5%. 

 Supporting these forecasts of continued GDP growth this and next year is the consensus outlook of economists polled by The Economist. The U.S. is expected to grow 1.6% in 2011 followed by a modest rise of 2.0% in 2012. Euro Area growth will remain positive but slump from 1.7% this year to 1.0% next year. The widening gap between the developed and the emerging economies, so pronounced in the IMF forecast, is also reflected in the consensus outlook: China is predicted to slow only modestly from 9.0% to 8.6%, whereas economists foresee India’s GDP will rise from 7.9% to 8.2%. 

 In review, the broadly accepted, probable scenario projected by professional economists is that the U.S. and Euro Area will muddle through with the support of continued strong growth in the emerging economies. Even though the economists do not believe recession is likely, they acknowledge that the global economic outlook has dimmed, the risk of a further deterioration has risen, and a further reduction in estimates may be necessary. All eyes will focus on the policy makers to take decisive action to raise consumer and investor confidence and restore healthy growth.

U.S. Economy: The Good and The Bad

Investors over the past few weeks have been beset by a strong dose of volatility in both news reports and stock markets. Economists disagree on where the U.S. economy will go from this point forward and their forecasts seem to get increasingly divergent by the day. A recent Bloomberg article, “It’s the Dog Days of Summer, Shall We Take a Double Dip?: The Ticker,” discusses varying views on the likelihood of a double dip recession. The article enlightens both the optimistic and pessimistic sides of the issue. Their conclusion indicates that although the U.S. and global economies are clearly moderating, the consensus scenario is that recession will be avoided.

The Bad:

Polls conducted recently by the Wall Street Journal and USA Today reveal that the consensus on the likelihood of the U.S. entering another recession has risen to 30%, twice as high as a few months ago. Economists generally accept that U.S. growth will be slower and unemployment will remain inflated for a longer period of time than previously thought. On August 22, Citigroup, Goldman Sachs, and JPMorgan Chase cut their 2011 and 2012 GDP projections. Finally, the need to reduce government spending will handcuff legislators from adopting stimulus measures and the Fed has few tools left to jump-start growth.

The Good:

The consensus on the likelihood of entering another recession is still below 50%. Bob Doll, the chief equity analyst at BlackRock, states: “Stocks have fallen 15% or more in the past few weeks, but since the Great Depression there have been 30 market declines of 15% -- but only two of those predicted a recession.” Even with their reduced U.S growth outlook, Citigroup will projects a 20% stock increase over the next 12 months. The jobs picture is discouraging, but is still strong enough to avoid recession. To be sure, the 12-month data regarding new jobless claims has improved and bank lending conditions have eased. Credit flows, an indicator of reinvested savings, continue to be adequate. Corporations are generating strong profits and carry record cash holdings. Recessions are usually associated with having a negative bond yield curve (whose short-term rates rise above long-term rates), and right now the U.S. has the opposite. Schwab economists sum up these positives with the observation that the U.S. will avoid recession “due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.”

The slowing U.S. economy is expected to have only a limited impact on global growth. For example, Morgan Stanley recently cut global estimated GDP growth in 2011 to 3.9 percent from 4.2. The dramatic fall of world stock markets in the past few weeks, which we consider excessive, discounts a much greater than 0.3 percent drop in global growth. For a more in-depth view of Marietta’s opinions on this issue, please refer to earlier posted blogs “Clouds Gathering on the U.S. and International Economic Horizon” and “Financial Market Turmoil.”