April 2013 Economic and Market Commentary
The recovery in economic activity in the United States appears to be gaining traction, but there are many headwinds which cause us to believe that the U.S. economy will not be able to sustain its growth rate the rest of the year. As a result, we are doubtful that the stock market can move much higher following the strong returns to start the year.
That is not to say that the economic data is not improving. In fact, the data has been stronger than anticipated and now many economists are optimistic that growth during the first quarter of 2013 Gross Domestic Product (GDP) rose 2 - 3%. The jobless claims numbers are slowly improving and are back to pre-recession levels. As a result, consumers are spending more, driving better-than-expected sales results for retailers. Durable goods orders also are up. Businesses have resumed spending to ramp up inventories, and the manufacturing industry is showing strength.
The main reason for the optimism is the improving picture in the housing market. Housing starts, permits, and existing home sales all continue to improve, causing the rise in home prices to gain momentum during the first three months of the year. Consumers and businesses are feeling more confident to spend, despite the higher taxes and gasoline prices they are experiencing.
While all of this is encouraging, there are many well-known potential potholes that could disrupt global economic growth. However, most investors have been willing to look past them because they are confident the continuing flow of stimulus coming from the U.S. Federal Reserve will allow for economic growth to continue strengthening. One can't help but wonder what will happen once the stimulus from the Federal Reserve stops, as it inevitably will. Will the economy be strong enough for growth to continue? It is possible, but cracks in the recovery have already begun to appear.
The approximately $85 billion in across-the-board federal spending cuts in 2013 due to The Sequester will hinder economic growth in the United States the rest of this year. Exports from the U. S. are likely to suffer as the growth in many parts of the world weakens. In addition, as the banking crisis in Cyprus reminds us, the financial crisis in Europe still has not been solved. The global economic recovery remains vulnerable, and the probability is rising that a negative shock will set it back.
In the United States, consumer confidence numbers have recently begun to deteriorate, which indicates that the higher payroll tax and rising gas prices are beginning to take a toll on consumers' discretionary income. It is also likely that the inability of the politicians in Washington D.C. to compromise on anything is affecting people's confidence that the Government can solve any of the issues that plague the country, such as the potential for tax increases to pay for rising Health Care costs, funding of current entitlements, necessary infrastructure improvements, and spiraling national debt.
Any one of these issues could cause spending and investing to grind to a halt. While we do not believe the U.S. economy will fall into a recession over the next year, with so much uncertainty we believe the economic growth projections are too optimistic and will not be realized.
The Stock Market
Stocks rose in most markets around the world in the first quarter, but nowhere was the move as dramatic as in the United States, where the S&P 500 Index was up 10.6%. By comparison, the MSCI EAFE Index of foreign developed countries was up 5.1%. Investors were drawn to the comparatively strong improvement in the United States economy and away from parts of the world perceived to be more risky. The MSCI Emerging Market Index was actually down 1.6%.
The uncertain outlook for the economic recovery makes the outlook for U.S. stocks the remainder of the year also very uncertain, but investors' concerns have been soothed by several factors. Stock valuations in the U.S. are very reasonable. Currently the trailing 12 month Price-to-Earnings ratio of the S&P 500 Index is around 15. This is about the historical average and below the typical P/E level when rates are as low as they are today. The Federal Reserve is keeping interest rates extremely low in the United States, so investors are funneling the flow of monetary stimulus into stocks, especially U.S. stocks, in order to earn a sufficient rate of return.
Corporate earnings, the main driver of stock prices, have remained strong in the U.S. Expectations for earnings are low for the first half of the year, but a combination of margin expansion and revenue gains are expected to drive double digit growth in the last half of the year. We are skeptical on both fronts, leading us to conclude that corporate earnings growth is likely to be disappointing the last six months of 2013.
With inventories having been replenished during the first quarter of the year, businesses will not need to spend as much going forward, which removes a major source of growth from the GDP equation. Also, trade is falling around the globe thanks to a recession in Europe and a slowdown in China. Finally, profit margins are at historical highs as companies bought labor-saving equipment to produce goods with fewer employees. With employment improving, it is hard to believe margins can remain at current levels.
In Europe, there has been no resolution to the sovereign debt crisis. The Cyprus banking crisis appears to have been solved, but it exposed that the Eurozone considers taxing insured depositors a viable option the next time a country needs to be bailed out. France, Spain and Italy are in a recession, and Italy's politicians still cannot form a workable government let alone deal with its deteriorating financial system. The probability of another financial crisis that would shock global financial systems has been elevated.
So while stocks may continue to move higher in the near term, the probability of a correction is rising. We remain cautious in our outlook for global stocks over the next three months.
Brian S. Sommers, CFA Director and Portfolio Manager
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