Since the beginning of the year, I have believed that the second half of 2014 would be positive for both the economies and the equity markets of the developed world.
Like many, I was surprised by the weak first quarter in the United States — real Gross Domestic Product (GDP) was -2.9 per cent — but I viewed that as a kind of mini-recession within an ongoing recovery and attributed it to severe weather conditions, accounting issues related to the Affordable Care Act and other factors.
I expected that the following quarters would exhibit renewed momentum based on the economic data being reported.
Almost every indicator I am now looking at is, in fact, showing a better tone to the economy. Vehicle production is running at 17 million units; consumer confidence and retail sales are improving; bank loans, which indicate a willingness by business people to borrow for inventories or new projects, are strong; capital spending is picking up; new plants are being planned or built; the unemployment rate is down to 6.1 per cent; and the number of jobs created in June was impressive. In addition, initial unemployment claims are down, small business hiring plans are positive and there are signs of wage increases in the service sector. Based on historical trends, we will not have to worry about wage acceleration until the unemployment rate hits 5.5 per cent, which probably will not happen before sometime next year.
On the other hand, the indicators are not universally positive. Housing starts, which had been running above one million units, dropped to 893,000 in June. Building permits also declined. For the economy to move toward 3 per cent real growth in the second half and for unemployment to continue heading to lower levels, housing has to be strong.
There were certain other negative signs, however, and these might explain why the market seems reluctant to move higher. The first is sentiment. Most investors are optimistic or complacent. The Ned Davis Research Crowd Sentiment Poll, which I have found helpful in the past, is extremely positive, and we all know that the best time to buy stocks is when most investors are negative. This doesn’t mean that the market cannot rise further, but it is a warning sign that a correction could occur before the next meaningful advance.
In contrast, a Bloomberg Global Poll found 47 per cent of the respondents thinking the market is close to a bubble, with 14 per cent saying we are already in one. This level of caution among the investment professionals who are Bloomberg subscribers is encouraging as a contrary indicator. The seasonals are also against the market. The summer is usually a difficult period, and in midterm election years the Standard & Poor’s 500 has suffered an average decline of 3.1 per cent versus a gain of .7 per cent for all years since 1950.
Another problem is the age of the market cycle. The average bull market usually lasts 57 months, according to Strategas Research, and appreciates 160 per cent. The S&P 500 has risen 186 per cent in the 61 months since the March 9, 2009 low. It has also been a long time since we have had a meaningful correction: about 700 days since a decline of 10 per cent and almost twice as long since a drop of 20 per cent. The market cannot go up forever. The question is, when will the pullback take place? Expansive Federal Reserve policy has helped the recovery, but now the Fed is tapering and investors are worried about an increase in short-term interest rates sometime next year.
Many investors are worried about a shift in Federal Reserve policy triggering a serious correction in the market. My own view is that we won’t see a rise in rates until mid-2015. Ned Davis Research has done a study of market responses to the first increase in interest rates by the Fed. It shows that the S & P500 does, indeed, have a sharp negative reaction, usually about 5 per cent, but then continues to move higher afterwards. The danger of a change in the inflation outlook could be one reason the Fed would consider raising rates, but that doesn’t seem about to happen. Not only are wages increasing modestly, but commodity prices have softened. I think inflation will remain reasonably tame, and we won’t need to worry about it until sometime in 2015.
Finally, the International Monetary Fund has reduced its estimate for World GDP real growth to a little more than 2 per cent. It was 4 per cent in 2010 and comfortably above 2 per cent until recently. There is a general perception that growth around the world is slowing. Over the past month, however, better economic news has come out of China, indicating that the growth target of 7.5 per cent will be reached. It appears, however, that an expansion of credit for spending on infrastructure and state-owned enterprises rather than consumer purchases is responsible for this. There also has to be an impact on the markets from geopolitical turmoil. The situation in Ukraine attracted worldwide attention when a Malaysian airliner carrying more than 300 people was shot down. And I think Iran will agree to reduce its nuclear weapons development program. There is too much pressure from the younger people there to have the sanctions lifted so they can begin to take advantage of the opportunities they see open to their counterparts in other parts of the world. Finally, In Asia, China will attempt to settle disputes in the South China Sea peacefully. Each of these trouble spots could erupt into something more serious at any time, resulting in a possible increase in oil prices or a challenge to the present world order that would be unsettling to the financial markets.
To close, taking a broad look at the economies around the world is probably useful. The United States is growing at 2 per cent — 3 per cent real, Europe at 1 per cent and Japan at 1.5 per cent. The emerging nations are growing faster, but their markets are generally not responding although there are some good values to be found there. The U.S. market is large, liquid, transparent and, in my opinion, not overvalued. Stocks are attractive on a multiple basis compared to housing and bonds. I think interest rates are likely to remain low for longer than most people believe and equities may perform well for longer as well.
At this point, I see neither a recession nor a bear market in sight even though we are five years into the economic and market recovery. Let’s hope geopolitical turbulence doesn’t upset that outlook.
— Byron Wien is the vice chairman of Blackstone Advisory Partners LP
