May 2015
Last year we wrote a newsletter that referred to the U.S. economy as a plow horse – slow, but getting the job done. While some of the details have changed, the overall picture of the economy has not. The U.S. has been seeing steady growth, with some quarters turning out more attractive numbers than others. While most investors would like to see greater growth, slow and steady growth is not bad. The broad market is at record highs, but is not excessively valued. While analysts are not predicting high rates of return from the U.S. stock market, nor are they expecting significant drops. The general consensus is that we continue to see slow, steady growth.
Gross Domestic Product (GDP)
2015 1st quarter GDP figures were low and caught most analysts by surprise. However, this is a repeat of the previous year. The winters of both 2013/2014 and 2014/2015 were unusually harsh in the Northeast United States. Charts that break out GDP figures by sector show drops in consumer goods and services both winters. This, along with falling oil drilling activity, took a heavy economic toll in the 1st quarter of 2015. Just as GDP rose for the rest of the year in 2014, we expect to see an increase in the 2nd quarter of 2015. While GDP was a mere 0.2% for the 1st quarter of 2015, that is much better than the -2.1% drop seen last year at this time. GDP rebounded nicely in the 2nd and 3rd quarters of 2014, and we would expect a similar rebound this year.
2014 GDP:
| Q1 2014 | Q2 2014 | Q3 2014 | Q4 2014 |
| -2.1% | 4.6% | 5.00% | 2.2% |
Source: Bureau of Economic Analysis
We will not see uniform growth across all sectors. For example, auto sales are expected to grow at 4-5% in 2015 compared to 10% in 2014. More incentives, higher inventories, and loans as long as 7 years all suggest that auto sales are starting to slow. However, pending home sales in 2015 are showing a sharp acceleration after a slow 2014, with homes sales up 11.1% year-over-year in March. Homes sales tend to drive purchases of retail goods. On the opposite end, the drop in oil prices has made exploration and drilling of new wells less attractive. This is expected to result in lower purchasing levels of the heavy equipment used in the drilling industry. Sectors seeing growth are expected to outweigh contracting sectors for the near future.
Inflation
Inflation is expected to remain at the low end of the average range (2-3%)1 for the near future. There are several large and contradictory contributors to the rate that make it an interesting back and forth story. Of course, the most dramatic recent contribution to lower inflation is the price of oil. The Consumer Price Index dropped noticeably from November through January, leaving March with a -0.1% annual rate.2 The drop in both gasoline and fuel oil prices are clearly responsible for this negative index rate. Food prices are up 2.3% from last year, medical care commodities are up 4.9%, and shelter is up 3.0%. There are other sectors that saw falling prices (used cars and trucks, apparel, etc.), but these are quite modest declines in comparison the energy sector figures which posted a -29.2% annual drop in gasoline prices and a -24.9% annual drop in fuel oil prices as of March.
We see upward inflationary pressure in the economy as sectors deal with the legacy of the housing crisis. The economy has been operating well below capacity (labor, capital & productivity) since 2008, which has held down inflation rates. It was nearly impossible for any business to raise prices in 2009 (at the trough of the economy) for the fear a competitor with excess capacity would not raise their prices, thus gaining market share.
Unemployment Rates:
| 2012 | 2013 | 2014 | 2015 est. |
| 7.9% | 6.7% | 5.6% | 5% – 5.5% |
Source: Morningstar Estimates
Excess capacity has shrunk considerably in 2015, due in part to lower unemployment rates. This has allowed some manufacturers and service providers to raise prices and rates. However, this is offset somewhat by long-term low population growth. U.S. population growth has slowed from 1.8% in the 1950’s to 0.7% currently and is expected to slow to 0.5% over the next two decades.3 Most of the developed world is also seeing a slowing of population growth. Less consumers automatically translates into less demand and less upward pressure on prices.
Low population growth is itself offset by pressures resulting from low unemployment. 2014 saw a shrinking excess labor force, resulting in labor shortages in regional airlines pilots, drywall installers and truck drivers. These industries then saw pay increases to attract and retrain workers. 2015 has seen wage increases in the retail sector, with Target, Wal-Mart and Gap all implementing wage increases. Wal-Mart increased their wages from $7.35 per hour to $9.00 per hour this year and noted plans to further raise them to $10.00 in 2016.3 The move at Wal-Mart will impact 500,000 employees. As excess labor continues to decline, we’ll see continued upward pressure on both wage and price inflation.
Combine all of these factors with the current low lending rates by the Federal Reserve and it gives us a fairly stable, low inflation rate. Analysts do expect to see an uptick in inflation and we agree with their overall theses – oil prices will rise at some point, the Fed will raise interest rates at some point, continued wage pressure will increase inflation to some degree. What is uncertain is the timing and the degree to which inflation will rise. We do not see any significant changes in the near future, but will continue to watch this area of the economy for the changes we expect.
Summary
The US bull market is starting to feel fairly mature as the market enters its 7th straight year of growth since the low in March 2009. The historical broad market price-earnings ratio (PE) average is near 15.5, with a fairly wide range for normal activity. The current broad market PE ratio of 20.65 is a bit high, but only at the high end of that average range. It does not mean U.S. stocks are seen to be richly valued, but does make the hunt for undervalued stocks poised to grow a bit more difficult than at the same time last year. This has narrowed the focus of the market as investors tend to look for more well-known stocks with growth potential and little chance of contraction, while avoiding much of the market that is felt to be fairly valued. We see a shorter list of securities attracting new investment than we did at the same time last year, indicative of a more mature market.
Low interest rates make a shift to fixed income securities more challenging than during similar periods in the past. There are bright spots for the investor though. The PE equivalent for international markets is low, resulting in attractive entry points to many international sectors. For this reason, we share a widely held viewpoint to continue to favor the international markets and add additional investments. We agree that broad international markets are poised for greater rates of return than broad U.S. stock markets and have increased the international weighting of many accounts this year in order to capture these expected gains. We are also looking at alternative investments like managed futures. There are some interesting alternative oriented investments that are managed with an eye towards low levels of risk that are appropriate for some portfolios. While we still look to U.S. stock exposure as the best way to grow client accounts, we are adding exposure to other sectors in order to properly diversify accounts in the current economic environment. As always, we will continue to monitor economic developments and adjust client portfolios to take advantage of changes as appropriate for each client.
1) http://inflationdata.com/inflation/inflation_rate/long_term_inflation.asp
2) http://www.bls.gov/news.release/cpi.nr0.htm
3) http://news.morningstar.com/articlenet/article.aspx?id=690965