Cyclical and emerging strength may be pointing to better growth, he says
Last week U.S. equities advanced as the S&P 500 increased by 1.3%.1 We have been amazed by the market's ability to continue to rally in an environment in which sales growth has been anemic and earnings gains have been largely based on companies' abilities to manage margins and utilize financial engineering.
Awaiting the self-reinforcing expansion
Despite a lackluster economic and profit backdrop, there are growing expectations that the Fed will continue with open liquidity taps, intensifying the search for yield and forcing investors into equities. It seems that corporations are taking advantage of this yield hunger by issuing debt, levering up their balance sheets and returning cash to shareholders. A greater risk for the global economy appears to be deflation. While quantitative easing by the Fed and other central banks may eventually result in higher final goods prices, a more immediate result may be higher prices for risky financial assets, especially equities.
Another critical issue is whether growth will falter again. We believe the chance of a growth relapse is relatively low. The housing recovery alone is only a small plus for the overall economy. Its effect on consumption, government revenues, improved collateral values, and a slowly-healing monetary transmission mechanism will help create a self-reinforcing expansion, although we believe the recovery could remain less vigorous than in past cycles. Until housing reached its trough, the economy could not begin to recover, and now further housing price gains and sales will continue to provide a modest economic tailwind.
Weekly Top Themes
Initial filings for jobless claims declined again, setting a new low for the cycle:2 The jobless claims fell by 4,000 for the week ended May 4, 2013. Since claims have now fallen three weeks in a row, this continues to send a reassuring signal about the health of the labor market. If claims can hold near current levels or fall further, we would anticipate a solid increase in private sector job creation.
The Fed's latest Senior Loan Officer Opinion Survey showed easing in lending standards and increases in demand for lending categories:3 The report was somewhat of an improvement, but reflects continued modest economic growth. The Fed survey tends to have a one-year lead on S&P revenues.
The macro tail risk from Washington continues to decline as the debt ceiling breach has moved from July to most likely October:4 The improvement is a result of higher than expected receipts from the expiration of the payroll tax credit and the tax raises associated with the fiscal cliff deal. This is likely to provide a much longer runway than was previously anticipated, and U.S. political issues should have less of an impact during the second and third quarters.
The Big Picture
We believe the market is suggesting improvement in the economy, not only by appreciation but also by internal action. In our opinion, factors generally associated with a cyclical upswing, such as beta and leverage, have begun to outperform for the first time this year, while those offering stability are starting to lose some steam. The next part of the story unfolded at the sector level two weeks ago, when cyclicals began to outperform while defensive sectors started to falter. For example, information technology, energy, financials, industrials and materials are all outperforming the broad market while consumer staples, utilities, health care and telecom are lagging.5
For equities, we believe the trend continues to be upward. For the bond markets, we expect a continued upward tilt in yields. Commodities are likely to continue to struggle until global economic activity is more robust. Higher dividend stocks and defensive stocks have become relatively expensive, and in our view many cyclical companies and emerging equity markets offer good value in a low growth world. We expect this shift to continue only if global economic growth improves, and more evidence is needed for those trends to continue.
Bob Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management LLC. This commentary originally appeared on the firm's website.
