From D.C. Tricks to S&P Treats—Weekly Market Review
Following a somewhat Kafkaesque two weeks of trying to handicap whether the partially shut-down U.S. government would breach its debt limit, investors greeted last week’s resolution of the D.C. standoff with a flurry of buy orders that pushed U.S. stock prices to record highs. As was widely expected, Congress squabbled until the 11th hour before finally voting to fund the federal government through January 15, 2014 and to increase the debt limit until February 7. Lawmakers also agreed to form a bipartisan committee to work on a 10-year budget plan.
I assessed the deal in an October 17 blog post. In short, while lawmakers will confront the issues of government spending and the debt ceiling again in just a few months, I do not expect another partial shutdown or credible threat of default. As for the latest version of a “Super Committee,” it’s possible (if not probable) that we’ll see some adjustments to indiscriminate, across-the-board spending caps. Such an outcome could, in the best-case scenario, combine more rationally selected cuts now with longer-term entitlement reforms. A failure would presumably result in no change to the spending limits currently in place.
Reading the Rally
Markets’ reaction to the end of the standoff is understandable, given how much they abhor uncertainty. Risk assets have rallied, but so have many of the defensive investment categories that took a beating last spring, when the Fed first intimated that it was planning to taper its large-scale asset purchases: anything to do with yield, staples, and the like. I’m on record favoring cyclicals and growth-oriented stocks over defensive categories, and I’ll stick with these preferences.
The market’s recent performance does raise the question of whether, now that much of the spring sell-off has been reversed, we’re going to relive that volatility once the Fed does begin to taper. My sense is that the market reaction won’t be quite as visceral. Investors have had a chance to digest the meaning of a taper, and likely better understand now that the Fed’s winding down of its $85 billion in monthly asset purchases maintains stimulus rather than actually diminishing it.
The selloff in emerging market debt had much to do with structural challenges in individual countries, not just the effects a Fed taper could have on the asset class. In fact, the weakness, however painful, also helped restore value in many instances. “Fast” money—investment based on short-term trading strategies—also played a role in the selloff, and with much of that having withdrawn from emerging market debt, the asset class is more likely to trade on fundamentals going forward.
Treasuries also sold off in the spring and early summer, and much of that selloff had to do with economic optimism attendant to the taper-talk. The Fed has gone to pains in recent months explaining that its decision to begin tapering would be data dependent, and by taking a wait-and-see approach in September, it signaled that the data were not yet as robust as expected. With Treasury yields down from their earlier peaks near 3%, fixed income investors caught unprepared by the rate backup may want to use this opportunity to reallocate away from interest-rate sensitive holdings in favor of greater exposure to credit.
Moderate U.S. Growth Outlook
Speaking of data, thanks to the government shutdown, we’re missing some important recent data points, most prominently the September payroll growth number (due finally to be released tomorrow, October 22). As government agencies resume normal operations, we should be able to fill in some blanks, but it’s worth noting that a number of monthly surveys and other data collections were never performed. We’ll have to live with some gaps in our understanding for some time to come. Maybe we can even wean ourselves a bit from over-reaction to oft-revised data releases.
Last week, the data that we did get were, by and large, positive. The Empire State Manufacturing Survey dipped in its October reading, but new orders—the key forward-looking component—were the best they’ve been since March. Similarly, the Philadelphia Fed Index also dipped but enjoyed strong new orders. Meanwhile, the housing market continues to contribute to growth. The Housing Market Index, released by the National Association of Homebuilders, slowed a bit in October, but it remains near the highest level in 10 years. The survey also notes a very high six-month sales outlook among builders. The data accord with the conclusions of the Fed’s October Beige Book, a compendium of anecdotal economic analysis from each of the 12 Federal Reserve districts. The report, released last week, characterizes the current pace of growth as “modest to moderate.” Of note are observations of uncertainty over fiscal issues and the impact of the Affordable Care Act, a general increase in consumer and business spending, rising demand for services and manufactured goods and lower price pressures, particularly from energy costs. With the national average for gasoline prices down to $3.36, according to the Lundberg Survey, Inc., I even saw a place to buy regular unleaded for less than four bucks in Manhattan. Hope that cheers the rest of you up a little.
Global Expansion Continues, Despite Emerging Market Challenges
U.S growth remains soft but steady, and probably took a small hit this quarter from the government shutdown. Globally, expansion should continue apace and even pick up in some areas, notably the Eurozone. Worldwide, 76.7% of purchasing managers’ indices (PMIs) were in expansionary territory—above 50—at last count, with two-thirds increasing in their last monthly reading. Year over year, almost 87% of PMIs have turned higher globally. Meanwhile, hundreds of central bank interest rate cuts over the past few years continue to create an easy monetary climate.
Many emerging markets (EM) have run into headwinds over the past year, but most developing economies stand to benefit from a pickup in the developed world, which could drive demand for EM exports and push commodity prices higher. Last week China announced that its economy grew at the fastest rate this year in the third quarter, with annualized GDP rising from 7.5% to 7.8%, if official stats are to be believed. Lest anyone become too excited, however, there were signs toward the end of the quarter that conditions were softening somewhat. Moreover, China continues to struggle with its objective of repositioning its economy to rely less heavily on credit growth, exports and investment, and more heavily on consumption—a more sustainable economic path. There has been little progress on that front so far this year, with investment accounting for over half of growth, and increasing amounts of credit required to deliver each unit of incremental growth.
Third Quarter Earnings Power Higher as Sales Lag
With the second full week of third quarter earnings season now past, 99 of the components of the S&P 500 Index have reported their results. Of those, 56% reported better-than-expected sales and 74% beat earnings expectations. Last week’s data continue the existing trend of above-average earnings on below-average sales. Valuations, even with the S&P 500 Index at record levels, are not especially lofty by historical standards, though they are above long-term averages. While investors (who were participating) have probably harvested most of the easy gains in the current rally, I believe there’s still room for appreciation. Multiples could continue to expand, and stocks still remain very cheap to Treasuries, based on a comparison between the S&P 500 Index’s earnings yield and Treasury yields. Investors should be selective, focus on growth, and remain cognizant of cheaper markets overseas.
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