The worst winter in the United States since 1995—96 has finally ended and the economy is responding favourably. I never gave up hope. I believed the housing recovery and energy production were enduring positives, but even those areas were experiencing setbacks. Early favourable signs were the sharp increase in bank loans (up at an annual rate of almost 10 per cent), which indicated improved business confidence, and a pickup in rail car loadings, which reflected strong order books across a broad range of sectors. First quarter real growth was down 1 per cent, however, showing the economy was at stall speed, but the late Easter may have contributed to that. Those cautious on the outlook point out that the harsh weather could only explain one per cent or less of the overall Gross National Product shortfall, suggesting that the quarter was fundamentally weak without considering the weather factor. I still believe momentum will build as we move through the rest of the year, and as a result we should see better economic growth and earnings.
The most significant change could come from capital spending. Until now, the money that corporations have committed to capital equipment projects has gone to purchase labour-saving devices in both manufacturing and service industries. Very few new plants have been built, which is understandable with operating rates at 79 per cent. We are now beginning to see evidence that capital expenditures are broadening to include new production facilities and this should result in a higher level of job creation. In April for instance, the economy did create 288,000 jobs in the United States and that provided support for the optimistic view. I am still looking for real growth to approach 3 per cent by year-end, which should provide a favourable background for earnings and the equity market. I also expect the unemployment rate to drop to 6 per cent.
Meanwhile, we are five months into the new year and the Standard & Poor’s 500 has made little progress (up about 3 per cent, so far). Various reasons are given for this result. Some valuation measures like that of Robert Shiller, which looks at normalised earnings over a decade, indicate the market is now overvalued at 25 times, a level high enough to warn investors that a decline is coming. My model, which is based on operating earnings over the next twelve months, shows the market multiple to be slightly above the historical median at 16.3 times and well below the valuation levels of previous tops (25—30 times). Others believe the excessive valuations of Tesla, Netflix, social media and biotech stocks are suggestive of a “bubble” and we all know what that means. A third group likens the Ukraine situation to the events leading up to the First World War. While that might be a stretch, an event in Occupied Palestine, Iran or the South China Sea could turn worse at any time, disrupting oil shipments and world trade.
Taking a hard look at earnings last year, revenue growth is clearly not the main factor contributing to increases. There have, however, been some recent improvements in earnings. We experienced a similar period of negative guidance between 2005 and 2007, but earnings expanded more than 8 per cent in those years. We could be in a period where the fundamentals (the economy and earnings) improve and interest rates stay low, but the market makes little progress. The reason could be related to sentiment, which is positive (a contrary indicator), and the fact that institutions are fully invested in equities as a result of the strong performance of the developed equity markets over the past two years.
Others believe that the market’s rise during 2012 and 2013 was fuelled by the monetary accommodation of the Federal Reserve and now, with the Fed reducing its bond-buying program by $10 billion a month, the liquidity that was the driving force of equity performance will diminish with a resultant negative effect on stock prices.
Another worry is that productivity is not increasing. Earnings have been growing at 5 per cent to 10 per cent over the past few years even though the economy has been growing at less than 3 per cent. Low interest rates and modest inflation have helped, but productivity improvements as a result of technology and tighter management have played a role. If productivity remains flat because those in charge don’t come up with new ideas to increase efficiency or technology advances are less impactful, profit improvements will be even more dependent on growth in the overall economy to produce increases. All of these factors are on the dark side of the outlook.
Perhaps the most impressive aspect of the current economic environment is the increase in merger and acquisition activity. In the past 111 days there have been 206 deals amounting to $1.7 trillion, a level comparable to 2007. There are two ways to look at this level of activity. The optimists would say that corporate executives and their boards are more confident about the outlook and are more willing to make substantial commitments to strengthen their strategic position. A more cautious investor would say that this is yet another sign of the animal spirits that usually precede a market decline. Since there are so many other factors on the positive side, I am siding with the optimists. The Institute of Supply Management manufacturing and service indexes have been rising steadily. Consumer credit is increasing, initial unemployment claims are declining, small business operators are becoming more optimistic and hotel revenues are strong, all signs of business confidence. Rising stock prices and house values have increased consumer net worth to more than $82 trillion, well above the $70 trillion peak of 2007. Another favourable sign is vehicle production. So far this year the seasonally adjusted annual rate has increased from 10.5 million units to a recent record of 11.6 million. The rig count is also picking up, which is a good sign. In 2010, 2011 and 2012 the economy slowed down during the summer and the stock market declined in sympathy. Some investors are worried that we could experience a similar circumstance, prompting a recall of the mantra, “sell in May and go away.” A shift in monetary policy took place in each of those years, however, and that doesn’t seem likely in 2014. The Economic Cycle Research Institute Index correctly forecasted the second half slowdowns in the U.S. economy in 2010, 2011 and 2012. It indicated the economy would not have a slowdown in 2013 and we didn’t have one. The index has moved up sharply recently, which provides reassurance that the current favourable economic signs will continue. My view is that economic momentum is about to increase, so the background for higher equity prices is favourable.
While investors in the United States may be relatively complacent about the unsettled conditions in Ukraine since February, their counterparts abroad have been much more concerned. That’s why Vladimir Putin’s decision to move troops back from the border of Eastern Ukraine (as yet unimplemented) and a non-turbulent election could be important to the equity markets. Petro Poroshenko won a majority and the turnout was strong. Now let’s see if he can bring the country together and develop a harmonious relationship with Moscow. Putin has said he will accept him as Ukraine’s leader. In another major geopolitical event, the outcome of the election in India was favourable and reform may at last be on the way in that complicated but important country. In contrast, events in the South China Sea seem to be heating up. China has had a confrontation with Vietnam over offshore oil drilling rights, which as of now is unresolved.
I continue to believe traditional economic factors like economic growth, earnings and interest rates will drive the equity markets this year and that geopolitical events will be background rather than central factors. Everyone involved has too much to lose by not taking advantage of the worldwide expansion underway, but we have to get used to unsettled geopolitical conditions involving Russia and China continuing to influence the investment environment.
Byron Wien is the vice chairman of Blackstone Advisory Partners LP
