Weekly Investment Commentary from Bob Doll, BlackRock's Vice Chairman and Chief Equity Strategist.
After many weeks of market disappointments, equities managed to post significant gains last week, with the Dow Jones Industrial Average climbing 2.8% to 10,211, the S&P 500 Index advancing 2.5% to 1,092 and the Nasdaq Composite rising 1.1% to 2,244.
The massive amount of fiscal and monetary policy that was enacted around the world in the wake of the Lehman Brothers bankruptcy has now been in place for close to 18 months, and investors are increasingly turning their attention to the manner in which countries may remove these stimulus measures. In general, we expect to see greater movement on the fiscal rather than the monetary front, since there is more work to be done on the former. Historically, the withdrawal of fiscal stimulus and the tightening of monetary policy often have been associated with the threats of “double-dip” recessions and equity market corrections. The key to preventing such a scenario is sustainable employment growth. Growth in employment translates into increased consumer consumption, which in turn causes an uptick in production, which can then result in additional employment gains, and so on. This sort of positive cycle can allow an economy to grow without the need for external stimulus. As a result, we expect most countries will not begin removing stimulus measures until clear signs of employment growth emerge.
Given this framework, it is reasonable to wonder where the world stands now. In the United States, we are now about 12 months into the economic recovery. Over that time, real gross domestic product (GDP) growth has been around 4%, equity market gains are comfortably in the double digits, the Case-Shiller Home Price Index has advanced close to 4% and, over the past five months, we have seen improvements in employment levels. From the perspective of where things stood one year ago, none of this would have looked likely. Over the next year, we expect economic growth will slow somewhat as stimulus is removed, but we are targeting real GDP advances of around 2% to 3%, thanks to continued low interest rates, improving employment, lean inventory levels and solid corporate profits. Outside of the United States, we expect some European economies will struggle given ongoing sovereign debt issues and believe the possibility of double-dip recessions is more likely in that region.
Regarding the stock market, we believe equities have already priced in the likelihood of somewhat slower economic growth in the coming months. We think volatility measures will remain high, and acknowledge that markets still remain subject to many risks, not the least of which is the high degree of uncertainty surrounding the European debt crisis. In any case, we believe the bulk of the current correction should be behind us and that the positive macro backdrop and improving valuations will provide a floor for equity prices. Investors will need to remain patient, since it will still take some time before base-building can allow markets to regain ground.
LOSING STEAM, From Charles Biderman, CEO, TrimTabs
It is becoming clearer that the U.S. economy is losing steam as the impact of the government stimulus fades and the Census Bureau starts laying off temporary employees. Wages and salaries are flat to lower sequentially. Income tax withholdings rose. Hiring also seems weak. The four-week average of initial unemployment claims rose to a six-week high of 463,000 in the latest week. We expect the economy to lose at least 200,000 jobs in June as the private sector remains modest and the Census Bureau lays off an estimated 275,000 workers.
The flows of equity mutual funds and leveraged U.S. equity exchange-traded funds suggest retail investors and day traders are complacent. We estimate that in June through Thursday, June 10, U.S. equity funds and global equity funds lost only $2.7 billion (0.07% of assets) and $1.4 billion (0.1% of assets), respectively, even though both fund categories posted month-to-date losses of more than 2% through Wednesday, June 9.
We believe the sovereign debt crisis has a long way to play out. Massive losses on bad loans from the credit bubble years will have to be absorbed eventually—it is merely a question of who will absorb them. Will it be bondholders—and stockholders—through defaults? Or will it be entire populations through inflation? Based on the bailouts and monetization that occurred in the past two years, we bet that the authorities will choose inflation. As the economy slumps again, central bankers are likely to launch multi-trillion dollar debt monetization programs. We suspect these interventions will eventually spark currency crises and trade wars.
BETTING ON TIPS, From Stephen J. Huxley, chief investment strategist, Asset Dedication
Buying and holding TIPS to maturity to supply a predictable stream of inflation adjusted income appears to be an even better strategy now than it was last year. Advisors who build immunized TIPS portfolios can manage market risk, default risk, reinvestment risk, along with inflation risk.
The breakeven point between TIPS and Treasuries has dropped since last year. Late last year, it would have taken an inflation rate of about 1.5% for TIPS to beat Treasuries over the next five years and 2.2% over the next ten years. Now it will only take an average inflation rate of 1.4% for TIPS to be a better deal over the next five years, 1.8% over the next ten years.
Historically, the chances are about 80% to 85% inflation will be higher than these rates over all 5-year and 10-year spans going back to 1927. This includes the Great Depression, of course. If one goes back only to 1947, the chances are about 90% for both five and ten years.
U.S. ECONOMY SHOWS RESILIENCE, From Liz Ann Sonders, senior vice president and chief investment strategist, Charles Schwab & Co.
While there remain many headwinds to the global economic recovery, we believe the United States has moved from recovery into a more-sustainable expansion, and we're optimistic on the equity market's prospects. In fact, the time it's taken for gross domestic product to reach prior highs, a feat completed by nominal GDP in the first quarter, has been relatively short, historically.
While talk has been growing of the possibility of a "double-dip" recession, fairly consistent economic indicators such as the yield curve (currently quite steep) and the Index of Leading Economic Indicators (LEI) suggest that the possibility of such an event in the near term is remote. The market pullback we've seen over recent weeks, with the Dow Jones Industrial Average posting its worst May performance in 70 years, has been disconcerting, but we believe it's more likely a relatively normal correction than the start of something more ominous.
Despite concerns growing about the global economy, led by Chinese economic growth slowing, the European debt fiasco and Japan's prime minister resigning, the US economy continues to show resilience. We're likely in a "soft patch," but that's not abnormal at this stage in the economic cycle; in fact, we've been anticipating a peak in the leading indicators, which often ushers in heightened volatility.
We expect housing data to be generally weak in the coming months as we "pay back" the gains seen in the past couple of months. Digging deeper, we can see that housing appears to be stabilizing and the prospects for more improvement are decent. Additionally, we've seen the jobs picture improve, notwithstanding last week's weaker-than-expected private payroll gains, with an average of about 200,000 jobs added to the US economy between January and May.
MOMENT OF TRUTH FOR EQUITIES, From Ibra Wane, strategist, Amundi Asset Management
Having reached new highs in mid-April, the markets plummeted even though quarterly results were up to expectations, valuations were not overly rich, and a concerted solution for the eurozone had just been unveiled. The surge in risk aversion was fueled by several factors. In Europe, the consequences of deficit-cutting could counteract the boost to exports from a weaker euro; in the United States, the recovery might actually be weaker than it seems because some of the drivers, such as the inventory cycle and fiscal and trade multipliers, will taper off; sustained momentum in emerging economies may falter because of preventive tightening and currency appreciation.
There is also uncertainty about the long-term pace of growth in developed economies against a backdrop of deleveraging. There is also the “echo chamber” effect that is particular to equity markets which can amplify imbalances. Moreover, a debate about the level of long-term interest rates has gradually edged out traditional concerns about earnings visibility and growth. And it undermines the argument that is generally favorable to valuations. If long rates were to rise because of an overall savings shortage, then the equity risk premium, currently generous, would become only relative.
THE WEEK IN REPORTS
Monday, June 14:
4-Weel Bill Announcement
Tuesday, June 15:
Housing Market Index
Wednesday, June 16:
Producer Price Index
Thursday, June 17:
Consumer Price Index