Our intermediate term (6-12 month) forecast for the U.S. and International economies and stock markets remains positive, but we continue to be cautious on the U.S. bond market.
- We expect global economic growth to strengthen in the second half of 2015. The U.S. is in the midst of a solid, moderate, self-sustaining expansion of about 3% GDP growth and conditions in Europe, Japan, and China will improve as growth initiatives implemented by policy makers take effect.
- Although we anticipate a higher U.S. market by later in the year, we note that concerns regarding first quarter earnings and Federal Reserve rate hikes may lead to heightened volatility in coming months.
- Many developed economies and markets, led by the Euro area and Japan, are recovering due to central bank stimulus programs, a decline in oil prices, and weakened currencies. Emerging economies, with the notable exception of India and possibly China, likely will continue to be troubled by soft economies, weak commodity prices, and looming Federal Reserve rate hikes.
- A strengthening U.S. economy, a modest rise in inflation, and Federal Reserve rate increases should slowly lift bond yields (and reduce bond prices) as the year advances.
The U.S. economy has entered a soft patch brought on by a combination of debilitating east coast blizzards and a west coast port shutdown. Nevertheless, the labor market has continued to make significant gains with the unemployment rate falling to 5.5%. While a March report from the Bureau of Labor Statistics confirmed the existence of the first quarter soft patch with nonfarm payroll employment growth well below expectations, it still represented a year-over-year increase of over 3 million jobs. We think employment gains and improving economic data will prompt the Federal Reserve to raise interest rates in the second half of the year, but we also think the rate increases will be too modest to negatively impact the recovery from the current slowdown.
The U.S. stock market will be challenged in coming months. One obstacle will be a projected year-over-year 6% decline in S&P 500 earnings in the first quarter at a time when the market itself is, arguably, modestly overvalued. This profits shortfall will, in part, be the consequence of disappointing energy earnings, which are expected to fall 63.5% year-over-year in the first quarter, and the sharp rise in the dollar, which will derail the earnings progress of many U.S. multinational companies. Excluding energy, the estimated earnings decline for S&P 500 companies that generate more than 50% of their sales from outside the U.S. is -1.3% (source: Factset). In addition, many investors are concerned that Federal Reserve rate increases will be a major negative for the stock market.
Despite the economic soft patch and the onset of the above headwinds, the U.S. market will continue to benefit from M&A activity, dividend increases, stock buybacks, and unattractive money market and bond yields. Further, there is a silver lining in the earnings picture. Companies which are outside the oil sector and have reduced international exposure are expected to grow earnings in the first quarter at a 5.9% rate, with more gains projected for the rest of the year (Factset). A gap may well open up between the winners and the losers in the market.
Going forward, we think investors will continue to focus on five salient trends that strongly impacted stock performance in the first quarter:
- International stock markets may continue to outperform the U.S. benchmark S&P 500 Index. As 2014 came to a close, the consensus view was that the U.S. stock market would outperform once again in 2015. Marietta’s last Outlook stated that international stocks could outperform if policy makers embarked on pro-growth stimulus measures. Since the December Fed meeting there have been over 45 easing moves around the world, including a massive quantitative easing program from the European Central Bank. The first quarter showed a sharp reversal of 2014 developments: the meager S&P 500 total return of 0.9% trailed the 3.5 % advance of the MSCI ACWI ex-U.S. Index. In contrast to 2014, taking a global perspective could be beneficial.
- A synchronized global economic acceleration in the second half of the year should stabilize commodity prices, including oil, but caution is warranted. Over the last 6 months, S&P 500 energy stocks are down 16.0%. A near-term forecast for the price of oil is unusually problematic. A recent Bloomberg article, “The Only Thing Oil Analysts Can Agree On Is Disagreement,” indicates the lack of consensus. Our best guess is for a modest recovery in oil prices IF oil companies cut production in the near future. In the meantime, energy company stocks will confront a dramatic plunge in earnings.
- The strong performance of healthcare companies merits an overweighting in the sector. In the first quarter of 2015, the best performing of ten industry sectors in the S&P 500 Index was healthcare with a return of 8.8%. The healthcare sector also was the best performer for the trailing one, three, and five year periods. The same pattern of outperformance extends to international healthcare companies. Clearly these strong gains reflect the aging populations of the developed countries; in the U.S. 10,000 baby boomers cross the 65 year milestone every day. Further, rising longevity and medical care improvements will increase the demand for healthcare products and services.
- Active stock selection, in contrast to passive investments in indexes, has returned to preeminence. Deutsche Bank recently reported that actively managed U.S. mutual funds are consistently outperforming their S&P 500 Index benchmark. To be sure, the S&P 500 Index, which in 2014 was among the most favored investments, not only is underperforming international benchmarks in 2015 but is also underperforming other benchmarks within the U.S. market. For example, in 2014, the S&P 500 led the S&P 400 midcap and the S&P 600 smallcap Index. In this year’s first quarter, the S&P 500’s meager gain was outpaced by smallcaps and midcaps. Furthermore, active stock selection tends to emphasize company earnings potential and momentum, and the Russell 1000 Growth Index (+3.4%) significantly outpaced the Russell 1000 Value Index (-1.3%) in the first quarter. Another noteworthy trend of this year’s first quarter has been the miserable performance of utilities stocks (-5.9%), whereas this sector soared 24.5% last calendar year. We think the utility sector will continue to reside in the lowest performance area of the S&P 500, which has been its home for the trailing three and five year periods.
- The strong dollar is damaging the prospects of large multinational company stocks. Numerous large multinational companies have indicated earnings problems. DuPont, IBM, Coca-Cola, Procter and Gamble, and other large U.S. corporate leaders have emphasized their declining competitiveness in international markets in contrast to the boost in profits enjoyed by international companies exporting into the U.S. One major reason for the rise of the dollar in 2014 was the weakness of key international economies, including the threat of deflation. In 2015, added pressure on the Yen and the Euro arose from central bank policies. In particular, the Japanese Yen has fallen 15.4% and the Euro has plunged 29.5% since last June 30. The widely anticipated rise in U.S. rates by the Fed, coupled with the expected monetary stimulus policies of foreign central banks, will tend to further strengthen the dollar and weaken key international currencies.
The combination of a strengthening U.S. economy, which brings with it the prospect of declining unemployment, rising real wages and tightening moves by the Federal Reserve, most likely will lead to a rise in bond yields. The increase, however, is likely to be limited by what we expect to be a cautious rate increase program by the Fed (we project a 0.50% – 0.75% Federal funds rate by year end) and by shockingly low yields in European bonds. As a consequence, we think the benchmark 10-year U.S. treasury yield will rise gradually from its current 1.9% to about 2.5% by the end of the year. We thus recommend short and intermediate maturities and, as always, investment grade quality.