Kristina Hooper, CFP®, CIMA® is head of portfolio strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Stocks dropped mainly on Spain last week, but a nascent recovery in housing, stronger-than-expected earnings and a pick-up in M&A activity may point to a healthier U.S. economy.
On Friday, Spanish officials raised concerns that the cash-strapped country’s economic situation would continue to be poor into next year, raising the possibility that it would need to restructure its debt. Fueling fears was Spain’s heavily indebted Valencia region, which requested 2 billion euros in government-sponsored financial aid. In addition, reports circulated that bank bailout money will not be disbursed until the end of 2012. The Dow Jones Industrial Average fell more than 100 points on the news.
While small-business sentiment worsened in June, Institutional Strategy & Investment (ISI) recently reported that institutional equity managers are now more optimistic. However, with employment still showing weakness and the euro-zone crisis remaining a critical concern, one has to wonder why these institutional investors are becoming more bullish. The data released last week may help elucidate why sentiment is improving.
Raising the Roof
First, the Federal Reserve released the Beige Book, its anecdotal report on economic activity. Overall, the report was mixed but one of the bright spots was housing. According to the Fed, “All district housing market reports were largely positive as sales and construction levels increased and home inventories declined. Rental markets continued to strengthen with rising rents being reported in Boston, New York, Atlanta, Chicago, and Dallas.”
The Fed’s upbeat report is supported by additional housing data: inventories are down and home prices have improved substantially in recent months. Indeed, the median home price has risen 22% in the first half of 2012. An increase in home values means higher household net worth, which typically has a significant impact on sentiment. And while existing home sales in June were down, new residential construction came in at 760,000 annualized, slightly higher than expectations. A closer look at the housing starts—the number of new permits to build homes—reveals that multi-family starts have steadily risen over the last 18 months. But single-family starts have only just begun to gain momentum, indicating a broadening in the housing recovery.
Another sign of improvement in the stock market is a pickup in mergers and acquisitions activity. PriceWaterhouseCoopers said last week that M&A activity is regaining momentum after an uptick in the second quarter. “During the first half of 2012, we’ve been extremely active in working with clients to prepare for a range of transactions,” said Martyn Curragh, PwC’s U.S. deals leader, “As deals continue to emerge from the backlog, we expect to see an increased level of activity in the second half of the year.”
Meanwhile, the Treasury Department recently announced that the federal budget deficit actually decreased from October through June. In addition, it saw a slight increase in individual income-tax receipts, which rose about 3% for the same period. However, the more impressive stat came from corporate-tax receipts, which rose almost 24%. While much of the increase in tax revenue was the result of tax law changes—particularly the expiration of certain business equipment purchase deductions—some of the increase was driven by stronger corporate profits.
Bottom Up, Top Down
In fact, U.S. companies’ bottom lines, generally, seem to be holding up well. As of this morning, 94 S&P 500 firms have reported earnings and the earnings-per-share beat/miss ratio is running at a strong 76%:22% (2% were in line), which is slightly higher than the five-year average beat rate of 74%, according to Deutsche Bank. Analyst expectations had been very cautious, so the surprises were mostly positive. Still, top-line growth has been a disappointment with just 44% topping analyst estimates, marking the worst quarter for revenue growth since early 2009. Deutsche Bank suggests the revenue shortfall could be the theme for earnings season, perhaps reflective of recent economic weakness. But perhaps the earnings surprises are the result of improved efficiency and productivity.
Of course, there are still many issues stirring up anxiety, particularly employment. Now that housing is showing signs of recovery, the job market is arguably the biggest sector of the U.S. economy in need of triage treatment. The euro-zone crisis and the impending fiscal cliff could potentially weigh the stock market down even further. However, institutional investors such as pension funds that are struggling to deliver sufficient returns to meet obligations, may be more focused on meeting longer-term investment goals. And they likely recognize substantial exposure to equities is needed. History has shown that short-term pain is often a tradeoff for long-term success.