Second-quarter U.S. macroeconomic results have continued to come in below expectations, while foreign economic developments became especially challenging in the euro zone. Fears of a hard landing in China have emerged as well. These headwinds have left the S&P 500 below the March 2012 close of 1,409 in the second quarter, with net selling pressure most evident in May’s cascading markets. As the quarter has come to a close, more evidence of favorable policy responses has developed. And this, along with the effective global tax cut implied by lower oil prices, should provide a better underlying tone to economic and earnings growth as well as U.S. equity market prospects.
The downshift in U.S. economic results that cropped up in the second quarter appears across too many indicators to dismiss it as noise. Curiously, the downshift was first evident in capital goods orders. On a three-month trailing average level basis, capital goods orders have fallen 7.6% from the February peak through April. Since we know government expenditures have been flat so far in 2012 (and down 2% year-on-year in real terms), and they are likely to be contracting more as we get deeper into 2012, it is extremely important that U.S. private-sector growth picks up momentum as the year progresses.
This is especially relevant because, in 2013, a roughly $650 billion fiscal drag is due to be introduced as tax cuts are allowed to expire and spending reduction efforts are redoubled. With high profit margins and ample free cash flow, we were anticipating capital spending would take the lead, opening up more jobs and fueling consumer income generation. While there is some increasing evidence of a return of manufacturing operations to the U.S. from offshore sites, and activity in the energy sector has remained robust, especially in the shale oil segment, the decline in order levels through April raises a yellow flag. Duke University survey results show some deceleration of chief financial officer capital spending plans, but they still remain positive at around 5% year-over-year growth. ISM new orders have also lifted of late from the March low of 54.5 to May’s 60.1, which is the highest level in nearly a year, so there is still a chance of some reacceleration in 2012.
As has been made all too apparent in the euro-zone situation, expansionary fiscal consolidations can work only if domestic private-sector spending revives or if foreign trade balances improve, in a more than offsetting fashion, against the fiscal expenditure cuts and the tax hikes. With the U.S. merchandise trade deficit only barely improved in April relative to year-end levels and export growth running at 4%year over year –roughly half the pace at the turn of the year—much depends on how U.S. capital spending and consumer spending evolves in the next six to 18 months.
On the employment front, initial unemployment claims have stopped falling, on a four-week trailing basis. Payroll employment gains have become a lot more tentative, shifting down to 69,000 per month from a peak of 275,000 per month at the beginning of the year. This has left real disposable income growth still below 1%, which in turn has left consumer spending too dependent on a drawdown in the personal saving rate. Retail sales growth has dropped mildly over the past two months, but with oil prices at eight-month lows, we anticipate a mild pickup in consumer activity in the third quarter
The failure of the momentum developing in the first quarter to spill over into the second quarter is a disappointment and will of course influence second-quarter earnings results. It has also accelerated the shift to defensive sectors in the U.S. stock market. Already, there has been some net reduction in analyst earnings revision activity for 2012 estimates. But we believe more of what has been weighing on the U.S. equity market are events abroad, including the prospects of a Greek exit from the euro zone and concern over a hard-landing scenario in China.
With the newly elected coalition in Greece, there is a much better chance that reasonable compromises can be hammered out, and the exit card is unlikely to be placed so readily on the negotiating table. Paradoxically, the threats of dissolution may be speeding up efforts at unification in the areas of banking regulation and supervision, region-wide deposit insurance and some form of redemption fund for lowering interest expense on a portion of the region’s debt.
Regarding China’s hard-landing scenario, the weak data arriving in April on electricity production, industrial production and retail sales activity have already prompted an accelerated policy response. At the People’s Bank of China, reserve requirement cuts have given way to policy rate cuts, while on the fiscal front, infrastructure spending has been accelerated as well, with initiatives now targeted at some of the more interior cities. Estimates indicate that this wave of spending will be between 25%-50% as large as the one initiated in 2008–2009. India has also responded in the past month with its own increase in infrastructure spending plans. A reduction in concerns over both China and the euro zone could help lift U.S. equities in the third quarter.
Stocks vs. Bonds
Finally, in the U.S., long bond yields are near historical lows, driving more investors who need income from their investments in the direction of dividend-yielding stocks. Low yields also help create a valuation underpinning for equities. With the U.S. Federal Reserve extending Operation Twist, and the possibility of QE3 to come if inflation continues to fade and growth remains subpar, there is little reason to expect competition from bond yields. Only in a deflationary environment would we expect bonds to outperform equities from here, and that is not our base case. Subpar growth, continued fiscal-policy ease in emerging markets abroad, diminishing inflation pressures and the possibility of some steps toward deeper unification in the euro zone all make us optimistic that U.S. equity indexes can bounce back from their May slump.