The Standard & Poor’s 500 finally broke above 2000, but has now fallen (hopefully temporarily). Federal Reserve Chair Janet Yellen has indicated that monetary policy will remain accommodative “for a considerable time” even though the bond-buying program of the last several years ends this month, and this suggests that the first increase in short-term rates will be later rather than sooner. The United States economy grew more than 4% in the second quarter after a dismal first and it now looks like second half real growth may trend toward 3%. Scotland voted to remain a part of the United Kingdom. Investors’ outlook reflects these favorable conditions; most surveys reveal an optimistic view.
Against this background, however, there are a number of troubling conditions which could change the positive mood. I still believe the rest of the year will be good for the economy and the market, but, like most observers, I have my worries. The first is valuation. The S&P 500 is now trading at about 17 times 2014 earnings and probably 16 times next year’s estimate. I look at trailing twelve month earnings and, on that basis, “bubbles” occur at 25 to 30 times, some distance from the current level.
The valuation context could change if earnings fell short of estimates. Right now analysts seem to be stepping up their forecasts. I started the year thinking the S&P 500 would earn $115, but there are now forecasts out there as high as $120 for this year and $127 for 2015. This has occurred in spite of the preponderance of negative guidance being given to analysts by the companies they follow. The favorable earnings outlook would change if the United States slipped back into a recession, but most of the indicators I am reviewing suggest that is unlikely to happen anytime soon. The one economic area I am concerned about is housing. With the improvement in employment and continued low interest rates I would have expected the monthly figures on housing starts, new and existing home sales, and mortgage applications for purchase to be consistently strong, but the data have been mixed. I wonder if there are some secular changes taking place in terms of more flexible lifestyles, as well as delayed marriages and family formations. Housing is a key component of growth, so this is an area that bears close attention.
At this point geopolitical turbulence appears to have receded as a market-influencing factor. The situation in Ukraine has quieted down with a cease-fire reported in the pro-Russian regions. President Vladimir Putin is negotiating for more political autonomy for the areas where separatism has strongest support with the hope that punitive sanctions will be lifted. The Russian economy has clearly suffered as a result of the conflict and Putin, having gotten much of what he wanted in Ukraine (as well as Crimea), seems to have opted for a more gradual approach to his objective of reuniting a part of the former Soviet Union. How long the cease-fire will last is an open question, but Europe needs Russia as a customer for its manufactured products and it also needs Russian gas as winter approaches. Europe was on a path to grow 1% before Ukraine erupted, and the conflict has reduced the likelihood of hitting that mark. If we are truly entering a period of negotiation rather than conflict, the 1% real growth target is back in place. In addition, the head of the European Central Bank, Mario Draghi, has announced several steps underway toward monetary accommodation, which should stimulate European growth. All of this is favorable for European equities and ultimately for the U.S. market and the dollar, but the situation is fluid and could reverse toward the negative at any time.
More troubling is the situation in Syria and Iraq. President Obama has ordered air strikes against the Islamic State of Iraq and Syria (ISIS) to prevent the further incursion of ISIS troops into Kurdistan and curb the power of that organization in the region. A number of Arab and European states are fighting alongside the United States. The U.S. has been able to gain more international support for this effort, possibly because the recent beheadings have dramatized ISIS’s barbaric brutality. It is doubtful that air strikes alone will do more than slow ISIS down. The first targets were oil-producing sites in Syria which provided revenue for ISIS’s military operations. ISIS already occupies a reasonable amount of territory which it is not likely to surrender. The Chairman of the Joint Chiefs of Staff Martin Dempsey has said that ground troops may need to be sent in, even though there is no popular support in the United States for that alternative. President Obama has said that the ground fighters will have to be Arabs and Muslims from other nearby states like Saudi Arabia, Iraq, Jordan, the United Arab Emirates and Qatar. While there seems to be broad approval for our air strike efforts against ISIS, there are risks. The organization’s Syrian headquarters in Raqqa is located in the heavily populated area and any bombing there would likely result in civilian casualties, thereby causing international criticism of our efforts.
Finally I worry about the South China Sea. As the second largest economy in the world, China can be expected to have a political voice that it wants everyone to hear. China believes it has fishing rights in waters claimed by Japan and the Philippines and oil drilling rights in offshore Vietnam. My view has been that China is not willing to go to war over these issues. Right now, the leaders are preoccupied with their reform program, which includes a vigorous anticorruption effort, regulatory changes and a rebalancing of the components of gross domestic product in favor of the consumer sector by diminishing investment in state-owned enterprises and infrastructure. That’s a full plate of domestic issues which I think will be the primary focus of China’s near-term initiatives. Foreign policy will be kept at a low flame.
I also worry about the dysfunctional democracy we have here in the United States. The current Congress is likely to prove to be one of the least productive in history in terms of producing legislation. I do not expect this condition to change even if the Republicans gain control of the Senate in November. That’s the bad news. The good news is that what happens in Congress over the next few months is not likely to have much of an impact on the economy or the market. The big worries are elsewhere. A market coasting on positive sentiment is, however, likely to overreact in the face of negative developments.
Byron Wien is the vice chairman of Blackstone Advisory Partners LP
