Stocks Are Strong, Economic Forecast Is Mixed

The Upshot

8/20/2012

Fueled by a rising stock market, lower jobless claims and lower-than-expected inflation, fear is largely being kept in check. But a far-from-flourishing US economy and a global slowdown may force the Fed’s hand with QE3, writes Kristina Hooper.

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.

Over the course of the summer, we’ve seen some welcome changes amid some worrisome signs.

After a difficult second quarter for the economy, in which the jobs picture deteriorated significantly, we’ve seen slow signs of improvement. The stock market is up, Treasury yields are up and fear is down, with the CBOE Volatility Index (VIX) at a multi-year low.

Make no mistake: The US economy is far from flourishing and continues to face serious challenges. But we see a mixed scenario for investors; the US is likely doing well enough to avoid recession, but not well enough to stave off a third round of quantitative easing (QE3). That seems to be providing the fuel to boost stocks, reduce the flight to safety in Treasuries and keep fear in check.

Perhaps the past week’s strongest news came in the form of a nice bounce in the July Index of Leading Economic Indicators, which rose 0.4%, exceeding consensus expectations. Among the positive readings were lower jobless claims and new building permits. However, new manufacturing orders declined—a troublesome indicator in an area that has already shown weakness in recent months.

Inflation Low...For Now

The July Consumer Price Index—or CPI, a proxy for inflation—was flat versus expectations of a slight increase, and consumer prices have risen just 1.4% in the past year. Energy prices, which have declined for four months in a row, were a major contributor to the low inflation number. However, inflation may not be as tame in the future, at least in the short term. Not only have crude oil prices increased recently, but CPI will likely be significantly affected by a rise in food prices due to the severe drought in the Midwest, which has already started to manifest itself in the July Producer Price Index number.

US retail sales and industrial production both showed improvement in July, decreasing the likelihood of recession. Industrial production slightly beat expectations while retail sales gained 0.8%—a strong rebound after three months of decline. The most recent housing report also reinforces the “not-too-positive, not-too-negative” nature of the current macroeconomic environment. New construction of residential homes proved disappointing In July, declining 1.1%, but housing starts are more than 20% higher than last year and building-permit issuance saw its largest gain in several years.

Even third-quarter earnings provided both positive and negative news. Of the 474 S&P 500 companies that have so far reported second-quarter earnings, 71% have reported earnings above the mean estimate. The incredible cost-cutting that corporate America embarked upon several years ago appears to still be paying off. However, just 42% have reported sales above the mean estimate. This top-line weakness is another cause for some concern.

Global Slowdown May Force Fed’s Hand

While we’ve seen some improvement in the US economy, the global macroeconomic picture does not seem as positive. Except for a handful of countries, including Germany and Austria, the euro-zone’s real GDP contracted in the second quarter. Moreover, further weakness in China and in emerging market export growth suggest world trade has slowed considerably.

As such, we anticipate the Fed will move ahead with QE3 as an insurance policy on 2013 growth, particularly given fiscal-cliff concerns. However, investors cannot be certain the Fed will deploy QE3, or that QE3 will have any significant impact on the economic environment.

What investors do know is that the Fed will keep rates artificially low, likely through 2014, and that many publicly traded companies have higher levels of cash on their balance sheets in recent years. We also know that valuations are very attractive on a relative basis, which has historically offered some downside protection when earnings disappoint. And we know that the S&P 500’s forward 12-month price-to-earnings (P/E) ratio is 12.7 versus the 10-year average of 14.4. This valuation attractiveness is broad-based: In eight out of ten economic sectors, the current forward 12-month P/E is below the 10-year average.

Given this scenario, with interest rates and valuations low, dividend-paying stocks may make a compelling portfolio component for investors seeking to meet their long-term goals.

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A Word About Risk: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.

Gross Domestic Product (GDP) is the value of all final goods and services produced in a specific country. It is the broadest measure of economic activity and the principal indicator of economic performance. The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility. The Standard & Poor’s 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index. The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time.

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