Thursday, October 31, 2013

Why Weak Economic News Might Be Good for Stocks

As we mentioned in last week's article, we are providing our most current outlook on global economic growth.  We will update our projections periodically to reflect our latest views.

Economic indicators have been very confusing for investors.  “Good news” about economic growth has been perceived by the markets as “bad news”, as it could lead to reduced monetary stimulus from the Federal Reserve.  In this article, we will identify some key economic information and separate each point into good news and bad news, then come to a final consensus as to our specific views about the economy and how it will impact stock market growth moving into 2014. 

1. Slow Economic Growth

Economic growth in the United States has been mostly flat coming out of the recession in 2008-09.  In the 2nd quarter of 2013, real GDP growth was a mere 2.5%.  The economy has been “muddling along” for quite some time.  We anticipate slow economic growth will continue into 2014. 

The Bad: Slow economic growth is not good for employment and those seeking employment.  Low demand for new workers puts very little upward pressure on employee wages.  That means little-to-no increase in discretionary income for households, which impacts consumption.

The Good: It is nearly impossible for inflationary pressure to build in an environment where job growth and wages are stagnant.  Muted inflation and continued employment problems will drive the Fed towards continued economic stimulus to satisfy their dual mandate of optimal inflation and employment.

2. Low Interest Rates

The Fed’s taper talks caused a spike in 10-year U.S. Treasury yields, which have fallen over the past few months and settled down near 2.5%.  Flat economic growth and inflation will likely keep Fed stimulus unchanged until early 2014.

The Bad: Interest rates are not likely to move higher until we see economic activity above 3.0%.

The Good: As the chart above shows, 30-year Mortgage rates have fallen below 4.5%.  Lower mortgage rates means more people can afford to buy a home or build a new one.  The housing industry is estimated to impact about 20% of the U.S. economy.  The low cost of borrowing is also very positive for other consumer expenditures (such as cars, etc.) and business investment.

In addition, we have said many times that “when the dust clears” and the shouts about Fed tapering calm to a whisper, interest rates will remain in a range between 2.5% to 3.0%.  Rates have fallen to the lower end of that range, which poses no headwinds against stock prices moving higher.

3. Falling U.S. Dollar

According to Yardeni Research, the trade-weighted dollar index has fallen to end-of-2009 lows.  As the chart below shows, the U.S. dollar is very low compared to where it has historically been.

The Bad: For major foreign investors in U.S. bonds, the after-currency-adjusted rates of return will be even less than the coupon rate.  When major buyers of U.S. bonds (countries like Saudi Arabia, China and Great Britain) start seeing negative currency-adjusted returns, they may start complaining in the media and initiating discussions about the U.S. letting their currency slide. 

The Good: A falling dollar makes U.S. exports much more competitive in the worldwide market, particularly in Europe and Asia.  That could mean positive earnings surprises in the 4th quarter of 2013 and 1st quarter of 2014 for companies with significant exposure to other countries.  That is of particular interest to us, as 60% of the earnings of the companies we own are produced outside the U.S. 

4. Positive Worldwide GDP

For the first time since 2007, 4 of the world’s major economies (United States, Europe, Japan and China) all have positive economic growth. 

The Bad: There can be nothing bad about this!

The Good: At the very same time the U.S. dollar is getting cheaper, the global economy is getting better, which is another indication that earnings for U.S. corporations could surprise to the positive.

5. Falling Oil Prices

Crude oil has dropped below $100 per barrel, which has translated to a fall in gas prices at the pump down to a U.S. average of $3.29 per gallon – down $0.27 from a year ago.

The Bad: One of the patches of strength in the U.S. economy is the current boom in both oil and natural gas.  The companies in these industries provide lots of quality, high-paying jobs.  If oil prices continue down, it would dampen earnings and potentially lead to reductions in employment.  We don’t anticipate oil prices are going to fall significantly.  Should they, however, there would be increased talks about the end of the oil boom.

The Good: In our mind, oil and gas prices act like a tax.  All consumers in developed countries are getting a break as a result of the fall in oil prices, which means more discretionary income, spending and modest improvements in the economy.

6. U.S. Government

It is very clear that Americans did not like the Republicans' role in forcing the government shutdown.  It is equally clear that voters do not like how the roll out of Obamacare is progressing, or NOT progressing. 

The Bad: The Government shutdown highlights bigger issues in Washington.  Republicans and Democrats are very divided on major issues, which has stalemated U.S. government function. 

The Good: In the entire Obama era, the Democrats and Republicans have never been in a position where reaching some sort of agreement has been so important to both government function and their political lives.  The only way they can get there is through a softening from both party extremes. 

While we don’t anticipate any major breakthroughs, we don’t expect either party will let another Government shutdown happen during the next round of debates in February 2014.  

7. Lots of Cash

Savings deposits have skyrocketed since 2008-09.  Investors and corporations alike are holding more cash now than ever before.

The Bad: Cash sitting on the sidelines means there is a lot of money out there that is not producing economic growth from investment into the stock market, small businesses or entrepreneurial activity.

The Good: Cash sitting on the sidelines also means the potential for investment is very high.  As interest rates continue to stay low, people are going to get tired of earning nothing and start looking for places to put their money to work.

Outlook for the Market

The economic and political headwinds against the stock market are fading.  Positive GDP growth from major countries around the world will help boost company earnings and create some earnings surprises.  We expect the economy will continue to grow very slowly, which will keep inflation and interest rates low.  

Low interest rates mean the abundance of cash earning very little interest will likely start moving somewhere for return.  With very little opportunity in bonds, there is only one place left to go: the stock market.