July 2013 Economic and Market Commentary
Even though the U.S. economy is still facing many headwinds, the recovery in activity appears to be gaining traction. As the second quarter came to a close most of the economic reports were surprisingly strong, and the Federal Reserve seems to believe the U.S. economy is healthy enough to continue growing even as the amount of stimulus is reduced.
The U.S. Central Bank wants to believe this is true because the United States Government simply cannot afford to continue indefinitely the approximately $85 billion per month in bond purchases, and a review of the economic data gives some evidence that supports their thought process.
The employment situation is slowly improving, causing consumer confidence to surge higher in June. Businesses are also feeling more confident, as durable goods orders were better than expected in May. The Richmond Fed Manufacturing Index also was much stronger in June than was expected, and the recovery in home prices continued in the second quarter.
However, the Federal Reserve might be a bit too optimistic considering there are still many headwinds as we enter the second half of the year. The across-the-board Government spending cuts due to the Sequester will hit the U.S. economy in the second half of the year. In addition, if interest rates continue to rise the housing recovery may be short circuited and consumer confidence could take a hit as more of their paychecks go to service their debt.
Meanwhile, growth remains sluggish in most other parts of the world, which has already begun to slow exports from U.S. companies. Most recently the credit crunch in China renewed concerns that the global economy is very vulnerable to slower growth in the world's second largest economy.
It remains to be seen if the economy can continue to improve despite these headwinds. Even if the Fed is correct, at best it seems likely the U.S. economy will continue on its 'muddle-through" recovery, especially considering the reduction of stimulus will also slow economic growth. In a worst-case scenario economic activity could begin to contract.
What will the Fed do if this scenario becomes reality? Based on recent history, every time the Fed has tried to end its stimulus, it ultimately needed to institute a new round of bond buying. It is debatable whether this has been the correct thing to do, but it is clear that the Federal Reserve is in a difficult position, and the risk of a policy error is high.
The Stock Market
June was a very volatile month in the stock market as investors were bombarded with conflicting data points. The economic releases in the U.S. were generally stronger than expected, but the data overseas was much weaker. Corporate earnings reports were essentially in line with expectations. Still, at times it seemed as if investors did not care about any of this because they were focused on the anticipated actions of the US Federal Reserve.
Stocks rallied during the first half of the year as most investors were willing to look past the economic uncertainty because they were confident the flow of stimulus coming from the U.S. Federal Reserve would continue. But since mid-May, when investors became convinced the Fed would soon begin to unwind the amount of stimulus being provided to the economy, the rally lost steam. Stocks were down in June, with the Russell 1000 Index falling 1.4%.
However, stocks in sectors that traditionally pay higher yields, such as Utilities and Telecommunications, fell further than those with lower dividends because of an expectation of rising bond yields due to a cutback in the Fed's bond purchases. But, the irony is that these stocks typically have a lower beta versus the market because they do not derive as much benefit from the Fed's stimulus. Meanwhile, those stocks that benefit the most from the stimulus outperformed lower-beta stocks despite anticipation the Fed will soon begin ending the program.
Ever since the financial crisis, central banks around the world have tried to reduce the perceived risk in owning risky assets such as stocks. To a large degree it has worked, but now investors are worried what will happen when the flow of stimulus slows. Investors dissect every word uttered from the Central Bank and are hyper-sensitive to any suggestion the stimulus will stop, which leads to exaggerated movements in stocks.
Most recently Fed Chairman Bernanke simply stated the obvious: the Fed might begin to scale back bond purchases later this year if the economic data supports such a move. But he also left the door open to continue the stimulus if the data doesn't continue to improve.
While the economic data is improving, corporate earnings growth in the U.S. has been declining. As the Fed's bond buying program ends investors will once again focus on corporate earnings reports to gauge the health of the recovery. Analysts have been reducing the earnings forecasts for the second quarter so it is likely most companies will meet these lowered expectations, but the real focus will be on the guidance these companies give for the rest of the year. Unfortunately, investors are likely to be disappointed.
According to Zacks Investment Research, consensus expectations are for earnings growth to accelerate from +2.7% in the first half of 2013 to +9.2% in the second half of the year. With interest rates rising, the sluggish global economy and a stronger dollar hindering exports by U.S. companies, and profit margins having peaked, it is unlikely corporate profits will meet these expectations.
The 3rd quarter is typically a weak time of the year for stocks. That trend could be amplified by the large gains so far this year, which leaves stocks vulnerable to a decline. So we expect stocks to struggle in the third quarter. Low beta stocks, which have underperformed so far this year, should lead the market during the second half of the year. The historical data indicates stocks that don't possess aggressive growth expectations, generate plenty of cash and have a history of rewarding shareholders through dividends and stock buybacks typically do well in in a slow-growth environment. We believe these stocks are also currently oversold and should do well going forward.
Brian S. Sommers, CFA Director and Portfolio Manager
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