- The waterfall sell-off in the equity markets this summer, combined with sharp declines in a variety of consumer sentiment readings and the rising concerns about the debt crisis, increased fears among market participants that the U.S. economy was on the verge of entering an economic downturn.
- Despite these challenges, the most critical economic readings have improved, suggesting that the demise of the U.S. economy has been greatly exaggerated.
- While we expect the S&P to move up from current levels by year-end, the ride is certain to be choppy as global uncertainty and risk remain, but the domestic news should continue to provide support.
Contrary to the double-dip recession fears that were widespread in the U.S. capital markets in early October, we still believe that the U.S. economy will avoid an outright recession. Record corporate cash balances, strong profits, solid demand for U.S. goods and services from the emerging markets, low inventory positions, and favorable investment tax incentives for business spending, should continue to produce gains in the industrial and business investment sectors of the economy.
Moreover, the moderation in energy prices from the spike earlier this year, the sharp reduction in consumer debt service costs, and the easing of supply channel disruptions associated with the earthquake and nuclear disaster in Japan appear to have produced an added boost to economic activity as real GDP growth rebounded 2.5 percentage points in the just completed 2011:Q3 quarter, with a healthy 3.6 percent gain in real final sales. Although our fiscal debt challenges in Washington will be a constraining factor on economic activity in late 2011 and potentially the next several years, we still look for real GDP growth in the U.S. to hover at or just above a two percent pace for the better part of the next 12 to 18 months.
Despite the recent doom and gloom fears about the U.S. economy, the bulk of the most relevant economic data has come in stronger than expected with labor readings, industrial production and consumer spending all showing improvement.
- The release of the employment report for September revealed that nonfarm payroll employment rose 103,000 last month (+137,000 excluding the government), with the prior months being revised upward by 99,000. This was significantly stronger than market consensus estimates centered at +60,000 and was well above the fear of several economists who were anticipating an outright decline in employment last month and the start of a U.S. recession. Likewise, household employment, which had been weak for several months, increased 398,000 in September.
- Industrial output expanded at a 5.1 percent pace in 2011:Q3, a sharp increase from the meager 0.5 percent pace in 2011:Q2. This increase reflected stronger output of business equipment (possible reflecting the benefits of the current bonus depreciation schedules) and a rebound in auto production (following the easing of the supply channel problems from Japan). Moreover, the auto sector is likely to provide additional support to the industrial sector and overall economic activity in the final quarter of 2011 as the current schedules point to an additional 25 to 30 percent increase in vehicle assemblies in late 2011. Interestingly, nonresidential fixed investments and business equipment & software expenditures, both key business components of real GDP, surged 16.3 percent and 17.4 percent, respectively, in 2011:Q3. These gains provide a further sign that the factory sector is in a structural growth mode.
- Various consumer sentiment and consumer confidence readings have once again proven to be misleading indicators, validating a lesson I learned more than 20 years ago: watch what consumers buy not what they say they are going to buy. Vehicle sales rose 8.3 percent in September to a 13.1 million unit pace, the highest level since April 2011. An aging fleet of vehicles (as more than half the cars in the U.S. are over 10 years old) and pent-up demand drove people to buy vehicles last month, with the strongest gains registered in highly discretionary luxury cars and pick-up trucks. Likewise, retail sales rebounded 1.1 percent in September, following an upward revision the prior month. The strength in non-auto retail sales was also centered in the discretionary spending areas including clothing, general merchandise, and furniture sales. The rebound at retailers last month provided a solid 2.4 percent boost to real consumption spending in 2011:Q3 as well as confirmed that the best measure of consumer spending is retail sales.
A glimmer of hope has also surfaced in the badly beaten housing sector. Housing prices increased and selected bidding wars unfolded among house hunters in Detroit, possibly reflecting a positive benefit of the improvement in the auto industry. Over the last several months, many consumers haven taken advantage of record low mortgage rates to refinance and reduce debt service payments. Moreover, the latest construction and housing data suggest that the housing sector could be a hidden source of growth to the economy in the second half of this year. Construction spending rebounded 1.4 percent in August, construction employment expanded by 26,000 workers in September, housing starts surged more than 15 percent in September, and new single-family home sales rose by 5.7 percent in September.
The U.S. Treasury Bubble
On September 23rd the yield on the benchmark 10-year U.S. Treasury note rallied to record low yield of 1.67 percent causing some to warn that market interest rates could fall even further. We didn’t buy that view then or now. Since late September, 10-year yields have jumped more than 60 basis points and while we expect continued volatility in the months ahead, the regime of very low absolute and relative interest rates is not sustainable over the long term and the possible reversal (“bursting of the U.S. Treasury bubble”) represents a substantial long term risk for both the global capital markets and the developed world economies. Moreover, the China bashing in Washington could also place upward pressure on Treasury yields given that China, which has been the major buyer of Treasury debt the last several years, could opt to change investment plans. Interestingly, the tide may have already started to turn as the latest data from the U.S. Treasury shows that China reduced its U.S. Treasury holdings by $36.5 billion in August.
Despite the implementation of a $400 billion “operation twist” by the Fed, the greater long term risk to the U.S. Treasury market over the next several years is for higher rather than lower market interest rates. Debt burdens have clearly been a driver of interest rates in the club med countries in 2011. A year ago we stressed that the debt crisis in Europe represented one of the greatest risks to global economic activity. Today, in the fall of 2011, our worries are shifting to concerns about the U.S. debt burdens as well. Owning sub-one percent five-year Treasury notes for the next five years appears to represent a greater risk than owning high quality, dividend paying equities, many of which trade 10 to 20 percent below historical valuations. We also see potential opportunities in the high grade corporate bond market and in shorter-duration high yield paper, but believe a more cautious exposure towards Treasury duration is warranted.
Evaluating Equities
Following the waterfall sell-off this summer, the S&P 500 Index generally hovered within a volatile 1120 to 1230 trading range. During the last several weeks, the better U.S. economic news discussed above helped to fuel a rally from the lows to the highs of this trading range. The combination of a bailout plan for Greece and a solid 2011:Q3 real GDP reading in the U.S. has now sparked an upside break above the top of this range.
The debt deal for Greece should prevent a Lehman-like event over the next several months. However, many challenges still exist in the southern European economies and the debt markets. Will Portugal, Ireland, Italy, and Spain seek debt relief packages? How will Europe get top line economic growth? Will the 50 percent haircut for Greek debt trigger a CDS default event? Will the rating agencies still downgrade financial institutions or countries in Europe? What will the IMF do? Unfortunately, the answers to these questions may not be as euphoric as the events in the capital markets the last 24/48 hours. Europe and its leaders will still have a tough road ahead.
However, for the U.S., positive domestic economic activity and corporate earnings should generally continue to drive domestic equity values. We still look for S&P 500 corporate profits to come in within striking distance of the $100 area this year and the latest quarter of earnings is showing another strong positive start as 193 out of 254 (more than 75 percent) of the S&P 500 companies have beaten their earnings estimates. For 2012, we look for earnings to approach the $105 area, suggesting that the domestic stock market is trading around 12 times next year’s earnings. If a domestic recession is avoided and if Europe eventually develops a true workout strategy for the region’s debt problems (the latest decision on Greece is a start on this process), the 1120 to 1230 trading range for the S&P 500 Index could eventually be replaced by a move up to the 1325 area. Interestingly, if the S&P 500 Index closes October above 1231 this would represent a key monthly reversal (a low below the prior month's low, a high above the prior month's high, and a monthly close above the prior month's high). This technical reversal is a rare event and could push trend-followers back into the stock market from the long side, especially if the S&P 500 Index closes the month above the 200-day moving average (1274).
Statements concerning Commonfund Group's views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group's policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.