Investment Perspective

Size: px

Start display at page:

Download "Investment Perspective"

Gabriella Mills
5 years ago
Views:

JANUARY 2015 Investment Perspective Major U.S. stock indexes increased in 2014 supported by improvement in our economy, earnings and valuations. The S&P 500 gained +13.

1 JANUARY 2015 Investment Perspective Major U.S. stock indexes increased in 2014 supported by improvement in our economy, earnings and valuations. The S&P 500 gained +13.7% while the Dow Industrials was up +10%. Economic highlights include the best employment gains since the late 1990s, record auto sales and a swift decline in gasoline prices. Over the past year, employers added 2.95 million jobs and the unemployment rate fell from 6.7% to 5.6%. The U.S. economy ended 2014 on a strong note and began 2015 with considerable momentum - its strongest pace in 11 years. Global economic growth (ex. U.S.) should increase +3.5% in similar to the year just ended We believe 2015 will be another positive year for equities. Our favorable outlook is driven by seven key factors: (1) solid momentum in economic growth and corporate earnings, (2) the benefit of the wealth effect on spending and investing, (3) the releveraging of balance sheets, (4) stimulus from lower energy costs, (5) the positive effects of massive monetary easing in Europe and Japan, (6) a healthy mergers-andacquisitions environment and (7) low inflation. But our stock market does need to overcome a few worrisome trends! For example, there is concern that the declining oil price may reflect weakening demand with recessionary conditions. However, the oil price decline appears to be a supply issue rather than a demand problem. Global oil demand growth remains positive and is expected to accelerate in Nevertheless, these worries warrant careful evaluation and raise the question, Will slowing growth in China and Europe offset a favorable economy in the U.S.? We address these issues below and highlight the fundamental factors supporting our constructive outlook. A summary of index returns for the year ending December 31, 2014 is as follows: Dow Jones Industrials +10.0% Russell % MSCI EAFE -4.9% S&P % NASDAQ Composite +14.8% Wilshire % 551 Madison Avenue / Suite 902 New York, NY P / F americancapitalmanagement.com GLOBAL ECONOMY Global economic growth (ex. U.S.) should increase +3.5% in 2015 similar to the year just ended. Several regions of the world continue to be restrained by aging demographics, overcapacity and austerity measures. In Europe, where sluggish growth is a problem, the European Central Bank (ECB) launched a $1.2 trillion bond-buying program to help stimulate the economy. The euro currency decline should also help exports. In Japan, economic conditions are slowly improving from two decades of stagnation. Aggressive pro-growth policies are expected to stimulate the consumer sector with higher wages, greater spending and more inflation. China s growth will

2 approximate +7.0% with downside risk as the country attempts to rebalance its economy from property investment towards consumption. China has begun easing monetary conditions and depreciating its currency to reduce the risk of a hard landing. Overall, the global economy could add +0.5% to GDP growth from the sharp decline in oil prices. The decline in energy costs represents a significant tax cut that will free up spending for other items The ECB recently responded with a stimulus program, but it will take time to exorcise the deflationary spirit from European markets U.S. GDP is expected to grow +3.3% in 2015 from last year s +2.4% pace. The economy strengthened considerably during the middle of last year with the second and third quarter GDP growth up +4.6% and +5.0%, respectively, but slowed in the fourth quarter. On balance, above-trend growth is expected to continue for several reasons. First, monetary policy remains accommodative despite the expectation of federal funds rate increases later this year. Second, government spending is no longer a drag on economic output. Third, housing-related spending as a share of the economy is trending higher. Fourth, household balance sheets are in excellent shape and should support greater consumer spending. Finally, the large decline in energy costs represents a significant tax cut that will free up spending for other items. Business and consumer confidence is strong, employment growth is improving and vehicle sales are the strongest since Business investment in equipment-related capex grew +11% annualized during the second and third quarter of last year and should continue growing at an above-average rate. On the flip side, energy-related infrastructure spending and employment will be negatively impacted until oil prices stabilize and the strong dollar will weaken export growth. The fundamentals suggest a durable, but moderate economic expansion. DEFLATION, DISINFLATION & INFLATION Deflationary trends in Europe and Japan continue to suppress global growth and moderate inflation in America. The ECB recently responded with a stimulus program, but it will take time to exorcise the deflationary spirit from European markets. In Japan, 20 years of deflation is ending due to massive fiscal and monetary stimulus, but confidence in a sustainable recovery is fragile. To demonstrate faith in the future, the $1.3 trillion Japanese government pension fund recently announced a plan to significantly reduce its bond holdings and buy sizeable allocations of global equities an unprecedented move. U.S. inflation is favorable with enough pricing power to calm worries of deflation, but not enough momentum to spark inflationary fears. Overall inflation is 0.8% y/y, but core inflation (excluding food and energy) is 1.6% y/y. Core inflation has fluctuated between 1.5 to 2.5% for most of the last 10 years relative price stability. The outlook for inflation remains moderate as prices are suppressed by worldwide deflationary trends, lower commodity costs, the appreciating dollar and excess global manufacturing capacity. However, labor markets are tightening, but data suggests a sizeable pool of employable people sitting on the sidelines. There are possibilities of higher inflation given the enormous amount of monetary stimulus over the last seven years. The key areas to monitor are labor, wages and the potential lagged inflationary effects of global quantitative easing. 2

3 Advanced technologies have dramatically increased American oil production over the last five years and now the U.S. is the world s top producer of crude oil and natural gas liquids ENERGY INDEPENDENCE The U.S. has made great strides in securing reliable sources of energy and reducing dependence on imported oil from OPEC. Advanced technologies have dramatically increased American oil production over the last five years and the U.S. is now the world s top producer of crude oil and natural gas liquids (ahead of Saudi Arabia and Russia, respectively.) Growth in crude oil production from shale formations increased fourfold from Shale now accounts for 40% of total U.S. production compared to 12% five years ago with 90% of this growth coming from North Dakota and Texas. The portion of U.S. consumption supplied by imports declined from 60% in 2005 to 21% the lowest level since The reduction in imported oil is leaving the global market oversupplied and, as a result, the price of oil has declined - 55% since last summer. This sharp price decline will impact the U.S. economy in several ways. The U.S. Energy Information Administration estimates the average household is expected to spend about $550 less on gasoline this year than in This should boost consumer spending and increase GDP growth by approximately +0.5% in Many businesses also benefit from cheaper input costs and transportation which, in turn, may boost hiring. Plant expansions to serve the U.S. market are increasing the demand for electricity, reversing years of stagnant electricity consumption. Demand is also increasing because of the growth of internet traffic and online services data centers since electricity is their largest operating cost. On the other hand, the plunge in oil prices is prompting exploration and energy service companies to cut capital budgets and personnel. This belt-tightening is starting to suppress a strong segment of the recent expansion. Oil and gas companies have been an engine of growth, providing steady employment, solid wages and fierce competition for workers. According to the Manhattan Institute, shale-oil and gas production have been the nation s biggest creator of solid, middle-class jobs across the economy since the recession ended in mid Ten million jobs are associated with the oil and gas industry in fields such as construction, education, food services, health care and transportation. Many of these jobs are now at risk. The uptick in the global M&A environment is noticeable with near record $3.4 trillion of mergers last year CORPORATE PROFITS In 2015, we expect S&P 500 operating earnings growth of +2% to $120 per share. Given strong economic momentum, we would typically expect earnings growth to be higher, but the decline in energy prices disproportionately hurts S&P earnings. Earnings have grown at a +9% rate over the last four years because of +3-5% revenue growth, improving margins, lower tax expense and continued share buybacks. We expect similar dynamics for many companies over the next two years supported by the recent pick up in the index of leading economic indicators (LEI) - one of the best indicators of earnings growth. Mergers and acquisitions (M&A) should also continue to play a role. In a bull market, deal activity accelerates as industry competitors react to a changing landscape the urge to merge psychology. M&A is a sign of confidence and strength. The uptick in the global M&A environment is noticeable with near record $3.4 trillion of mergers last year reflecting renewed confidence and higher stock prices that emboldened both buyers 3

4 and sellers. In the U.S., deal activity surged +54% to $1.5 trillion and initial-publicofferings (IPOs) of companies raised $96 billion for 293 deals. Both figures were the highest since 2000, the height of the dot-com frenzy, when 432 IPOs raised $105 billion. These trends contribute to the self-reinforcing growth dynamics. The combination of moderate economic growth with low inflation and interest rates is favorable for the U.S. equity market particularly for growth companies The Fed will be patient and carefully monitor economic conditions abroad and delay tightening if global deflation risks escalate Despite the positives, three factors deserve attention as potential headwinds to earnings growth. Foreign sales of U.S. companies will be negatively impacted due to the dollar s appreciation as well as a decline in sales growth in the regions suffering recessionary conditions. About a third of S&P 500 revenues and approximately 45% of after-tax profits are earned abroad. Thus, 10% appreciation in the dollar versus key currencies can reduce S&P EPS by -2.5%. Also, energy companies will likely experience a sharp profit decline that will offset the positive earnings growth in other sectors. These factors could hinder S&P 500 earnings by approximately $8-10 dollars per share. Companies with minimal exposure to currency appreciation and/or declining energy prices should experience good growth. INVESTMENT OUTLOOK The combination of moderate economic growth with low inflation and interest rates is favorable for the U.S. equity market particularly for growth companies. However, a major portion of the world lacks sufficient economic momentum and these diverging trends create uncertainty for investors. The key question is, Will the U.S. stock market advance amidst these uncertainties? We believe the answer is yes! The domestic economy is solid and the stock market is reasonably valued at 16.7x estimated S&P operating earnings of $120 per share considering a 10-year Treasury yield of 1.68% and inflation of 0.8%. This price-earnings multiple compares to the long-term average of 16.6x and 19.0x during periods of low inflation and interest rates. There is also upside to earnings growth if Europe improves or energy-related earnings are better than expected. Looking ahead, the stock market will experience periods of correction and consolidation as investors digest the significant gains of the last six years - the S&P 500 is up +208% from the March 2009 lows. Short term caution is warranted as we have experienced a rapid series of new highs (53 new highs in 2014) without any pullbacks of more than -10% in almost three years. The last three meaningful corrections were -9.8% in October 2014, -11% in May 2012 and -22% in the summer of Additionally, investors will exercise greater selectivity as quantitative easing ends and the Fed starts raising short term interest rates. It is important to note that the Fed will be patient and carefully monitor economic conditions abroad and delay tightening if global deflation risks escalate. The ECB has begun a sizeable quantitative easing program to promote growth which should be a positive development for the global financial markets. At the same time, the central banks of China and Japan will take further measures to stimulate those economies. Accordingly, global monetary accommodation remains a key strength of the current environment for liquidity and investment. 4

5 From a technical perspective, the market remains in a constructive pattern with the moving averages steadily rising. The 50-day moving average has remained above the 200-day average since the 2011 correction and the market has rebounded from each test of support. Historically, the average stock market gain during the third year of an incumbent president is +9.9% versus an average of +7.5%, and is up 75% of the time. Additionally, the fifth year of the decade has always provided positive equity returns with an average gain of +25% since These are favorable indicators. We advocate using buying opportunities to build positions in quality small and medium-sized growth companies as the multiyear outlook for equities remains favorable The stock market began this year with a decline in January. Does the January trend matter? The old stock market adage is so goes the first day, week and month, so goes the year. But that adage was not true in the S&P 500 increased +13.7% for the year despite declining in January. Nevertheless, when January is up, the year is up 80% of the time with an average return of +13.0%. Conversely, when January is down, the year has a 44% probability of increasing with an average decline of -1.9%. Since 1928, this compares to positive annual returns 67% of the time and a compound annualized return of 9.6% for the S&P 500. We believe the investment outlook is constructive based upon sustainable growth and improving investor confidence. The potential buying power for equities is substantial as stocks are under-owned by institutional and retail investors. The pace of equity fund inflows remains well-below historical trends, which highlights the opportunity for better flows in the future. U.S. equities may also benefit from a flight to quality among international investors as the rising dollar triggers reallocations. We expect to achieve a positive return in 2015, but recognize that negative surprises can unsettle the psychology of the market and increase volatility. We advocate using buying opportunities to build positions in quality small and medium-sized growth companies as the multi-year outlook for equities remains favorable. The key risks include: cyber-attacks, European recession, Chinese hard landing, Russia/Ukraine, geo-political conflicts, sovereign debt or major currency crisis, deflation or an overheating U.S economy with accelerating inflation. In closing, 2015 is the Chinese Year of the Ram the best performing Chinese zodiac sign. The stock market experienced an average return of +26% during Ram years since The Ram only moves forward an enviable quality. Its calm, stable and stubborn disposition suggests a successful year. But the Ram is easily frightened and volatile! Appendix: Summary of Key Economic and Financial Measures Yearend 2013 Yearend 2014 Difference/ Change Fed Funds Rate (%) Yr. Treasury Yield (%) bps Inflation (CPI y/y % ch.) bps Gold ($/oz.) $ 1,204 $ 1,184-2% Oil ($/barrel) $ 98 $ 53-46% Euro per Dollar % 5

Investment Perspective

JANUARY 2018 Investment Perspective Today, the investment outlook is favorable with solid growth, low inflation, healthy consumer confidence and positive investor sentiment The overall economic tone has