Written by Douglas M. O’Rear, AIF® - Chandler, O’Rear & Associates
Looking ahead to 2015, I see a year that will be marked by transitions. Likely changes in monetary policy around the world, the return of volatility, and the recent shift in the political balance of Congress could mean 2015 is a year that will have the global economy, markets, and central banks all on the move.
LPL Financial Research has identified significant elements that will be in transit in 2015, which include:
The U.S. economy continues its transition from the slow gross domestic product (GDP) growth of 2011–2013 to more sustained, broad-based growth. Ongoing progress in the labor market, an uptick in wage growth, and continued improvement in consumer and business spending have propelled an uptrend in U.S. economic output. LPL Research expects that inflation—which has historically accelerated as the economy moves into the second half of the business cycle—is poised to continue proceeding higher, but only modestly so.
Central banks around the world will also be on the move in 2015. In the United States, the economy is likely to continue to travel toward a point where the Federal Reserve (Fed) will begin raising interest rates, albeit gradually, for the first time in nine years. The Eurozone and Japan—the world’s second and fourth largest economies, respectively—could benefit, as central banks in those regions embark on more aggressive policy actions aimed at restarting and re-accelerating their long-dormant economies.
Washington shifts from a relatively quiet 2014 to take a bigger role in 2015. The Republican takeover in the Senate and approaching debt ceiling limit might provide the opportunity for some movement out of the gridlock that has plagued Washington in recent years.
Against this backdrop, LPL Research forecasts the following:
The U.S. economy is expected to expand at a rate of 3% or slightly higher in 2015. This forecast matches the average growth rate over the past 50 years, and is based on contributions from consumer spending, business capital spending, and housing, which are poised to advance at historically average or better growth rates in 2015.
Tempered by increasing levels of volatility, stocks may be poised to advance 5–9%. LPL Research expects continued economic growth, benign global monetary policy, and a more favorable policy climate from Washington indicate that the powerful, nearly six-year-old bull market should continue. This forecast is in-line with the average stock market growth of 7–9%, since WWII. Supported by improved global economic growth and stable profit margins in 2015, expected earnings per share growth for S&P 500 companies is 5–10%.
Expect flat bond market returns. With sustained improvement in economic growth, slowly rising inflation, and the approach of the Fed’s first interest rate hike, bond prices are likely to decline in 2015. LPL Research believes high-yield bonds and bank loans with their attractive yields can help investors manage this challenging bond market.
To help investors prepare for an expected market in transition, LPL Research has compiled timely advice into its Outlook 2015: In Transit publication. Transition, as is described in this publication, is just another word for change. The forthcoming change in the economic and market landscape in 2015 offers great opportunities, but also major challenges, likely in the form of increased volatility. However, as LPL Research forecasts relatively strong economic growth unfolding over the horizon, the bigger threat to most investment portfolios will be the pull of our emotions. It is human nature to weigh market struggles substantially more than the strong market returns between them. As investors, keeping our emotions in check when confronting increased volatility could be the key to potential success in 2015. With an investment strategy in hand and a destination in mind, LPL Research believes 2015 is poised to be a potentially favorable, though perhaps volatile, year for investors.
Powerful, Nearly Six-Year-Old Bull Market
We believe stocks will deliver mid- to high-single-digit returns in 2015, with a focus on earnings over valuations. We believe 3% economic growth, benign global monetary policy, and a more favorable policy climate from Washington indicate that the powerful, nearly six-year-old bull market should continue.
Historically since WWII, the average annual gain on stocks has been 7–9%. Thus, our forecast is in-line with average stock market growth. We forecast a 5 – 9% gain, including dividends, for U.S. stocks in 2015 as measured by the S&P 500. This gain is derived from earnings per share (EPS) for S&P 500 companies growing 5 – 10%. Earnings gains are supported by our expectation of improved global economic growth and stable profit margins in 2015. We expect stocks, not bonds, to be the precious cargo for investors in 2015.
The coming year will be one marked by transitions. Cycles that are in transition can cause potential fluctuations and volatility even if they have historically provided solid stock market performance. The most important cycle, the economic cycle, is unlikely to reach a recession destination in 2015, positioning the stock market to potentially offer up solid gains to investors. In fact, since 1950, in years during which the U.S. economy does not enter recession, the odds of a positive year for the S&P 500 were 82%, with an average gain of 11%. Recessions do not run on a set schedule and are difficult to pinpoint in advance, but our belief, based on our favorite leading indicators for the economy, is that the probability of recession is very low and stocks could potentially send investors solid returns in the coming year [Figure 1].
Overseas, policies already in place — and those that we expect to be enacted over the course of 2015 — are likely to be big drivers of global growth. We expect the U.S. economy will expand at a rate of 3% or slightly higher in 2015, which matches the average growth rate over the past 50 years. This forecast is based on contributions from consumer spending, business capital spending, and housing, which are poised to advance at historically average or better growth rates in 2015. Net exports and the government sector should trail behind. As the economy continues to grow at a moderate pace in 2015, we expect this expansion to potentially take us into 2016, where we could likely find tightening labor market conditions and a rising fed funds rate.
The United States is in the middle stage of the economic expansion, presenting investment opportunities and risks for investors. While the U.S. economy has grown over time, the growth has not been in a straight line. The variations in the pace of growth around the long-term trend are called economic cycles. Economic cycles have four distinct stages: recession, early (recovery), middle (mature), and late (aging).
By historical standards, the economic recovery that began in mid-2009 has been by far the most tepid recovery on record, with GDP through third quarter 2014 just 11% above its 2009 trough. In all recoveries since the end of World War II (WWII), the economy expanded 24% on average in the first five years of recovery. The current recovery even lags the last three (beginning in 1982, 1991, and 2001), which we believe are the most comparable. Five years into those recoveries, the economy stood 16% above its recession lows. The pace of this recovery thus far has lagged behind those prior in each of the major GDP categories [Figure 1]. Read the Full Report here Weekly Economic Commentary 12012014
The S&P 500 Index hit another set of fresh record highs last week (November 10 – 14, 2014) and has achieved the midpoint of our total return forecast (10 –15%) for the year with a 12% return year to date. While we continue to recommend keeping the majority of equity allocations in the United States, as we have for a while, we think it is a good time to look at opportunities that have lagged behind the strong U.S. stock market and may have become attractively valued, possibly setting the stage for a reversal. One such area is emerging markets (EM).
It has been another tough year for EM equities. The MSCI EM Index has returned just 1.4% year to date, far behind the S&P 500 (though MSCI EM Index has outpaced the developed foreign benchmark, the MSCI EAFE Index, which has returned -2.6% year to date) [Figure 1]. EM have struggled for many reasons, including but not limited to lackluster earnings, Federal Reserve (Fed) tapering and the subsequent end of quantitative easing (QE), related concerns about current account deficits due to trade imbalances and borrowing abroad, geopolitical unrest in Ukraine and the Middle East, the drop in commodity prices, a strong U.S. dollar, and growth fears in Europe and
China. So with all of those challenges facing investors, is it time to buy EM? To answer that question, let’s look at fundamentals, valuations, and technicals.
Japan Check-In: Will the Weak Q3 GDP
Reading Draw a Policy Response?
Japan reported a 1.6% annualized decline in real gross domestic product (GDP) in the third quarter of 2014 over the weekend of November 14 – 16, 2014. Policymakers in Japanese Prime Minister Shinzo Abe’s government and at the Bank of Japan (BOJ), as well as most market participants, expected a solid gain in GDP in Q3, not a decline. The consensus of economists polled by Bloomberg News was looking for a 2.2% gain in GDP in Q3, after the Japanese economy contracted more than 7% in Q2 2014 in response to a big value-added tax (VAT) increase imposed in April 2014. (We’ll discuss the VAT in more detail below.) As a result of the unexpected decline in GDP in Q3 [Figure 1], Japan’s economy has met the unofficial definition of recession (i.e., two consecutive quarters of negative GDP) and has entered its fourth recession since 2007. How long Japan’s economy remains in recession — and more importantly, the policy response to the latest recession — may help to determine the trajectory of global growth in 2015 and beyond.
The Consumer Disappoints
Consumer spending, which accounts for 60% of Japan’s economy, rose just 1.5% in the third quarter, after the VAT increase led to a 19% drop in consumer spending in the second quarter of 2014. Most market participants — and probably the BOJ and the Abe administration — expected…
U.S. economic growth has been subpar — right around 2% — during much of the ongoing economic expansion. Yet, the S&P 500 has returned nearly 230% cumulatively since the bear market low on March 9, 2009. How did that happen and is it justified?
Before trying to answer to those questions, it is worth pointing out that this situation is not all that unusual. In fact, since 1950, the S&P 500 median return is 13% (average is 12%) when real gross domestic product (GDP) grows less than 3%, with the S&P generating a positive return 68% of the time. However, a good portion of those returns come during recessions — historically, the best time to buy stocks is at recession troughs. But even if we take those periods in and around recessions out of the equation and look at annual returns when GDP growth is between 1–3%, the median (and average) S&P 500 return is a respectable 7–8%. Stocks tend to like average (or slightly below average) growth, which is not strong enough to generate worrisome inflation.
Now back to the question of what has driven this stock market to far outperform economic growth. Some might say quantitative easing (QE), which ended at the end of October 2014 in the United States (the Bank of Japan expanded its QE program last week on Halloween). While QE has benefitted U.S. stocks (how much is up for debate) by helping keep interest rates low and encouraging investors to buy riskier assets (see this…
The Federal Reserve’s (Fed) policymaking arm, the Federal Open Market Committee (FOMC) met last week (October 27 – 31, 2014) and decided, as was widely expected, to end its bond purchase program known as quantitative easing, or QE. While the FOMC retained its promise to keep rates low for a “considerable time” after QE ends, it set the bar fairly high for restarting another round of QE. At the end of this week’s commentary, we’ll present some metrics to help answer the question many are asking in the wake of last week’s announcement: Did QE work? Our view is that it is probably too soon make the final call as to whether QE “worked,” and we’ll leave it to the economic historians, pundits, and politicians to debate that in the years and decades to come. One thing we know for sure is that no one can ever know what would have happened to the United States and global economies had the Fed (and other central banks) not embarked on QE during the uncertainty generated by the collapse of Lehman Brothers and its aftermath in late 2008 and early 2009.
QE Is Still Needed in Japan and the Eurozone QE was also in the news in Japan last week, as that nation’s central bank, the Bank of Japan (BOJ), ramped up its QE program, surprising markets, which had mostly expected the BOJ to wait until early 2015 to dial up its QE program. Late this week, November 3 – 7, 2014, the Eurozone’s central bank, the European Central Bank (ECB), will hold its monthly policy meeting. We continue to expect the Eurozone to expand its QE program, but in our view, that expansion is not likely to be announced this week. Although the results of the bank stress tests conducted by the ECB (which will take over this week, for the first time, as the bank regulator across the Eurozone) were released last week, the ECB is likely to wait to see some progress on the fiscal front (i.e., more government spending and tax cuts to help support the Eurozone economy) before it proceeds with the expansion of its QE program. We acknowledge, however, that the earlier than expected action from the BOJ to expand QE puts additional pressure on the ECB to do more — and sooner rather than later. As we noted in our recent (September 25, 2014) Weekly Economic Commentary, “Central Bankapalooza”:…..
No Signs of Global Growth Scare Impacting Main Street as Modest to Moderate Economic Growth Continues
The Beige Book is a qualitative assessment of the U.S. economy and each of the 12 Federal Reserve (Fed) districts. We believe the Beige Book is best interpreted quantitatively by measuring how the descriptors change over time. The latest edition of the Fed Beige Book, released last Wednesday, October 15, 2014, ahead of the October 28 – 29, 2014, Federal Open Market Committee (FOMC) meeting, was timely, given the increasing concerns in global financial markets about a slowdown in global growth. The qualitative inputs for the October 2015 Beige Book were collected through October 6, 2014, and thus captured at least three weeks or so of the elevated market concerns around global growth centered around Europe, the rise of the Islamic State in Iraq and Syria (ISIS), the social unrest in Hong Kong, and the concerns about the spread of Ebola to the United States.
In our view, the latest Beige Book reflected a picture of the U.S. economy that was largely unaffected by any of the concerns noted above, and again described “modest to moderate economic growth (in the U.S. economy) at a pace similar to that noted in the previous Beige Book” (September 3, 2014) and that “employment continued to expand at about the same pace as that reported in the previous Beige Book.” However, as it has over the past year or so, the October 15, 2014, Beige Book noted that “some employers had difficulty finding qualified workers for certain positions” and that some reported “upward wage pressures for particular industries and occupations, such as skilled labor in construction and manufacturing.” In the past, these characterizations of labor markets have been a precursor to more prevalent economy-wide wage increases. In general, optimism regarding the economic outlook far outweighed pessimism, as it has for the past 18 months or so. The “modest to moderate” description of the overall economy has now been used in the last 12 Beige Books and in 13 of the past 14 dating back to March 2013.
To provide a snapshot of the sentiment behind the entire Beige Book collage of data, we created our proprietary Beige Book Barometer (BBB) [Figure 1]. In October, the barometer ticked down to +82, down from a +97 reading in September and the +102 readings seen in both June and July. The +82
The S&P 500 fell 1% last week (October 13 – 17, 2014) in volatile trading, leading market participants and media pundits to speculate on how far the stock market slide—now just over 6% from the September 18, 2014, closing high — might go. In last week’s Weekly Market Commentary, “Pullback Perspective,” we cited the economic backdrop, central bank support, and valuations as reasons the pullback was unlikely to turn into a bear market (a 20% decline). This week we turn to an area that has already entered bear market territory and discuss our outlook for oil and the energy sector.
Why Does Oil Matter?
Oil has a significant impact on several key sectors of the economy:
Consumer spending. Consumers spend, on average, 4% of their income on energy (including oil, natural gas, refined gasoline, etc.). As a result, a sharp drop in energy costs can help provide a boost to consumer spending, particularly important as holiday shopping and winter heating season approach.
Capital spending. Energy accounts for one-quarter of all capital spending globally, more than any other sector. Oil and gas exploration and production is very capital intensive, and significant infrastructure investments are needed to support the U.S. energy boom.
Transport sector. Oil influences transports as a cost (fuel for airlines,shippers, trucks, etc.), but it also provides growth opportunities as an increasing amount of oil and petroleum products are transported by truck and rail due to the boom in U.S. energy production [Figure 1].
Keys to Finding a Floor
After falling 25% from its summer 2014 highs, West Texas Intermediate (WTI) crude oil, a long-accepted benchmark for U.S. oil prices, began to find its footing in the $81 – 82 range late last week (October 13 – 17, 2014). We believe this lower range may hold for several reasons: Slower global growth is already reflected in oil demand forecasts.
Expectations for global oil demand have fallen significantly in recent months in response to slower growth in Europe, which is teetering on the brink of another recession. The International Energy Agency (IEA) cut its outlook for 2014 oil demand growth by 200,000 barrels per day, or 22%, from the agency’s prior forecast of 900,000. To give some perspective,…
Gauging Global Growth in 2014 & 2015
Update: Acceleration Expected
The outlook for global growth is important to investors, since it defines the ultimate pace of activity that creates value for countries, companies, and consumers. As investors begin to digest the S&P 500 earnings reports
for the third quarter of 2014, we provide an update on how consensus
estimates for economic growth for 2014 and 2015 — in the United States and
worldwide — have evolved over the past few years.
The International Monetary Fund (IMF) cut its global growth forecasts for both
2014 and 2015 last week (October 6–10, 2014), noting that the outlooks for
the Eurozone, Brazil, Russia, and Japan have deteriorated since the summer
of 2014, the last time it released a forecast. The IMF’s downgrade of global
growth — along with its warning about a “frothy” equity market — was cited
by many market participants as the catalyst for the equity market sell-off and
related volatility last week.
As we have noted in our previous updates on the global growth outlook,
the new forecast from the IMF should not have generated the reaction it
did. Typically, when the IMF releases a forecast, the majority of financial
market participants take little notice of the report. Why? Because consensus
forecasts for global gross domestic product (GDP) growth are available
monthly from sources like Bloomberg News, and because markets constantly
react to changes in projected paths of economic growth amid the daily,
weekly, and monthly drumbeat of economic data and global events.
Why Global GDP Growth Matters
In the past, prospects for U.S. economic growth garnered the most attention
from market participants, but in recent years markets have focused more
on the prospects for global GDP growth. Why does global GDP growth
matter? As we have noted in prior Weekly Economic Commentaries, financial
markets — especially equity markets — focus intently on earnings. Broadly
speaking, earnings growth is driven by “top-line” growth, or revenue
growth, less the costs incurred earning that revenue, with labor accounting
for more than two-thirds of total costs. A good proxy for global revenue