Newsletters 2010 Newsletters Where's Goldilocks?
Monday, 14 June 2010 19:07
Equities worldwide tumbled in May, with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite off 7.29%, 8.20% and 8.29% respectively. These important barometers for the U.S. stock market are now down 2.30%, 2.79% and 0.53% for the year and have all sustained corrections between 10% and 15% from their recent peaks.
Since publishing last month’s “Canary in a Coal Mine” newsletter on the perils of profligate government spending and unsustainable deficits, the stock market has become obsessed with Europe’s debt woes and its potential impact on the U.S. economy. Indeed, whereas the stock market had begun to price in “escape velocity”, a sustainable economic recovery, investors now fear a dreaded “double dip” recession.
Not to get too bogged down in technicalities, but we’re unsure how a “double dip” is even possible, since the National Bureau of Economic Research (NBER) hasn’t yet declared the end of the Great Recession that “officially” began in December 2007. The fact is that there has been but one “double dip” recession in the United States since the Great Depression. That single “double dip” occurred when the U.S. entered recession in July 1981, only one year after the briefest recession in U.S. history (January to July 1980) ended, with GDP having contracted by 2.8% and unemployment having reached 10.8%. That recession was brought on by very tight monetary policy under the Volcker Fed and became exacerbated, after only a brief reprieve, by rising oil prices and further Fed tightening. Since the term “double dip” is being tossed around as though it were ordinary, we thought some historical context might be helpful.
While the recession of the early 1980s is the only modern-day recession to witness a “double dip”, the recent Great Recession has frequently been compared in magnitude only to the Great Depression. Yet there was no “double dip” associated with the Great Depression. The Great Depression lasted three years and 7 months, from August 1929 to March 1933, with GDP having contracted by 26.7% peak to trough and unemployment having reached 35.3%. Though it may not have felt like much of a recovery because of the very high rate of unemployment, the U.S. economy expanded from March 1933 to May 1937, when it reentered recession four years and two months after the Great Depression. This recession of 1937 lasted until June of 1938, with GDP having contracted 3.4% and unemployment having peaked at 26.4%. While the recession of 1937 was no “double dip” because of the long gap between periods of contraction, hand-wringers may find hypothetical comparisons between the fiscal austerity measures taken to balance the budget post “New Deal” (the arguable cause of the recession of 1937) to what may happen today once government stimulus is removed. Tight monetary policy is also deemed to have played a role in causing the recession of 1937.
Today, unemployment is materially lower than during the Great Depression and lower even than unemployment during the recession of the early 1980s. The level of GDP contraction today is consistent with the recession of the early 1980s but nowhere near that of the Great Depression. And perhaps the greatest difference between now and these other, awful recessions of modern day America is the fact that today’s Federal Reserve remains entirely easy, not restrictive.
Rather than forecasting an imminent “double dip”, the stock market may be reevaluating the V-shaped prospects for this recovery and adjusting itself to the realities of the “new normal”. The term “new normal” was coined by Pimco’s Mohamed El-Erian to describe a post-crisis economic environment characterized by below-trend growth, higher regulation and higher unemployment as the world goes through the long process of de-leveraging.
The silver lining in Europe’s sovereign debt crisis just may be that it has given the Federal Reserve yet another reason to continue its easy monetary policy longer than otherwise might be expected. With U.S. unemployment stubbornly high and very real prospects for a “double dip” in Europe, the Fed will remain highly accommodative for an “extended period”. Fed Chief Bernanke recently testified that while he could not rule out a “double dip” in the United States, he noted an “important transition” for the economy which he expects to “recover at a moderate pace”. Bernanke also cited low mortgage rates and lower prices for oil and other commodities as benefits for consumers and the U.S. economy directly tied to euro zone weakness.
Another glimmer of hope from the European debt crisis is that euro member countries are being forced to take the fiscal medicine necessary to keep their currency union intact. In that regard, Europe may emerge over time with stronger growth than pre-crisis levels. There remains an outlying possibility, however, that the euro nation union collapses. A collapse of the euro would be highly disruptive to the global economy.
Euro nations with the most significant exposure to this crisis include Greece, Spain, Portugal and Ireland. Together, these countries account for approximately 20% of euro zone GDP. The International Monetary Fund estimates that GDP for these countries will contract by 6%, implying that the overall hit to euro zone GDP will be just over 1%. Germany and France ought to benefit from the soft euro which might actually offset weakness elsewhere. The European Central Bank now expects euro zone GDP to grow between 0.7% and 1.3% in 2010 and between 0.2% and 2.2% in 2011. Reports that German manufacturing orders rose by 2.8% in April versus the expectation for a 0.4% decline indicate that the euro zone’s strongest economy had at least some economic momentum built up just prior to the acceleration of the crisis. And the fact that yields on 10-year German bunds have fallen to 2.5% indicates that Germany is perceived to be a safe haven. While there is no denying that euro zone weakness presents a drag to the global economic recovery, it is estimated that only 9% of overall S&P 500 revenues are derived from European sales. Total overseas sales account for roughly 30% of S&P 500 revenues.
Sans Europe, much of the rest of the world, especially emerging economies, are experiencing better than expected growth. The expectation that China’s GDP could be sustained near 10% seemed to be validated by a recent report that Chinese exports surged by 48.5% in the 12-month period through May, leading to a trade surplus of $19.53 billion for the month. And India just reported stronger than expected GDP growth of 8.6%. Especially with weakness in Europe, China and other emerging economies are more vital than ever to the global economy.
Recent economic reports in the United States have also been better than expected, leading a Wall Street Journal survey of 53 economists to predict that the U.S. economy would grow roughly 3% in the second half of 2010 and continue at that pace in 2011. This is roughly in line with Bernanke and the Fed’s view that GDP will expand by 3.5% this year. However, even Bernanke acknowledges that this pace of expansion is not strong enough to quickly improve the outlook for job creation, stating that there will only be a “slow reduction” in unemployment. While the unemployment rate dropped from 9.9% to 9.7% in May, the private sector was able to create only 41,000 jobs for the month.
Only time will tell if the euro zone crisis will lead to an imminent reduction in U.S. economic activity. Similar to data points out of Germany, it appears that the U.S. has built at least some economic mojo going into the crisis. Consider the following:
- Real disposable income increased by 0.2% in March after two consecutive months of little or no growth. This was the first month of year over year wage growth since the recession began and bodes well for the 90% of the American workforce that have jobs.
- Real personal consumption increased by 0.5% in March.
- Construction spending increased 0.2% in March, ahead of the expectation for a decline of 0.3%.
- The ISM Manufacturing Index increased from 59.6 in March to 60.4 in April, slightly beating expectations for a rise to 60.0. And at 59.7, the ISM Manufacturing Index for May came in ahead of expectations for 59.4.
- Factory orders rose 1.3% in March, well above the consensus expectation for a decline of 0.2%.
- The ISM Services Index for April matched the 55.4 read for March.
- Industrial production increased by 0.8% in April, just ahead of the 0.7% expectation.
- The Philly Fed Business Outlook survey rose in April to its highest level since December 2009.
- Durable goods orders surged 2.9% in April, well ahead of the estimate for an increase of 1.5%.
- Construction spending rose by 2.7% in April after rising 0.4% in March, the first two consecutive months of growth since 2007 and the strongest monthly report since August 2000.
- The Conference Board’s Consumer Confidence Index rose to 63.3 in May, easily beating the consensus estimate of 58.3 and registering its highest level since March 2008.
To be clear, the recovery in the United States comes hand-in-hand with unprecedented economic stimulus and orchestrated, generational low interest rates. Weakness in Europe will help keep U.S. interest rates low and the dollar strong. There used to be a time not long ago when the combination of low interest rates, strong dollar, benign inflation and moderate growth came to be known favorably as the “Goldilocks” economy. While it seems clear that the economy is “not too hot”, investors are presently uncertain as to just how “cold” the economy may prove to be, especially with looming structural headwinds – higher deficits, higher taxes and eventually higher interest rates.
Meanwhile, corporate America is in fine shape with cash on the balance sheet at 11% of assets, a sixty-year high. Corporate earnings have continued to surpass expectations, but the euro zone crisis will certainly lead to currency adjustments for companies with significant European operations. According to Thomson Reuters, the consensus earnings estimate for the S&P 500 is $85.26 for 2010 and $96.61 for 2011, implying a PE ratio of 12.7 for 2010 and forward PE of 11.2, with the S&P 500 currently trading at 1082. We would not be surprised if these estimates are chiseled down, especially for 2011.
If we apply a historically reasonable PE of 15 on a potential lower range of earnings, say between $80 and $90, we still come up with a target range for the S&P 500 at 1,200 to 1,350. While the risks have increased, a year-end 2010 target of 1,200 for the S&P 500 still seems very reasonable, a potential gain of 11% from current levels.
Potential downside and upside catalysts are visible. Should the euro union unravel, China experience a hard economic landing due to a real estate bubble or Iran’s nuclear ambitions become more pronounced, the S&P 500 could very well drop back below the 1,000 threshold. Should Congress come to a compromise on taxes or reach agreement on means to control our deficits, November’s elections ring in a new class of fiscal conservatives or the U.S. economy prove more resilient than is currently expected, the S&P 500 may trade through 1,300 in the next year on its way to testing previous highs within the next several years.
Of course, it is impossible to precisely predict what the eventual outcome for the market will be. Periods of steady earnings, low interest rates and low inflation have typically been associated with “Goldilocks” premiums for stocks. However, increased macro-economic, global uncertainties, in the context of navigating through the aftermath of the worst recession since at least the early 1980s and perhaps the Great Depression, necessarily give us pause and influence a more cautious approach to client portfolios. On average, as of mid-June, we have approximately 15% of client portfolios in cash and another 25% invested in short-term corporate and municipal bonds. We remain convinced that, while subject to bouts of volatility, high-quality, large cap companies with strong balance sheets, predictable earnings and dividend growth and well-pronounced prospects in foreign markets will provide superior investment returns over the coming years, especially on a risk-adjusted basis.
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