Economic Perspective

A Monthly Commentary

^{May 2012}

It may not feel like a recovery but the U.S. economy has grown for ten quarters following a six quarter recession that ended in June 2009.  During this period, growth has averaged 2.5%.  The path to recovery, however, hasn’t been easy.  With GDP sliding to 0.4% in the 1st quarter last year, investors feared that we were headed for a double dip recession.  These fears thanks to the European debt crisis, gridlock in Congress and slowing growth in emerging markets have resurfaced.  Yet growth picked up in each quarter since then strengthening the case that the economy getting back on track.

Stocks have followed a similar volatile but steadily rising wall of worry.  After falling 57% during the recession, the S&P500 index has rallied nicely over a period of almost three years.  More recently, after a beginning year rally, investors became nervous about the market due to fears of a repeat of a mid-year correction that hit stocks in both 2010 and 2011.  Stock performance improved when the Greek bailout received European support.  Current concerns about the Fed’s simulative bias through a potential 3rd quantitative easing have led to more market swings.  Although these ebbs and flows are likely to continue, we see the economy on the road to recovery.

A major concern for investors relates to the 2nd half stock market melt down experienced both in 2010 and 2011.  As we approach the same period this year when stocks began to fade, investors fear that history will repeat itself.  However, unless we have another confluence of shocks like the European financial crisis in 2010 or the Japanese earthquake and Tsunami in 2011, we will likely see a gradually improving economy and stock market for the balance of 2012.

So are we back on track?  The progress we’ve made on the jobs front seems to suggest that we are.  Initial jobless claims which peaked in April 2011 have declined for seven straight weeks.  Except for a slip to 120,000 jobs in March, non-farm payrolls have added a monthly average of 163,100 jobs since October 2010 and over 200,000 jobs in December, January and February.  ISI company surveys of business activity have been rising.  Vehicle sales are up, consumer confidence is improving and manufacturing and purchasing indexes in the U.S., Europe and Asia are rising gradually.  Bank delinquencies are declining.  Consumer spending has shown resilience driven in part by a slowdown in inflation.  Even home prices are stable or rising in some regions.

This has led to strong corporate earnings as companies pare costs creating lean operations that are highly leveraged to small increases in revenues.  For the 4th quarter, 70% of all S&P500 companies beat expectations and earnings grew 12.3% in aggregate making it the 8th consecutive quarter of double-digit growth.  4th quarter GDP came in at 3.0% and grew 2.2% in the 1st quarter this year.   Expectations are for 3rd quarter GDP to grow in the 2-3% range and S&P500 earnings to grow 6%.  Companies with strong balance sheets are using cash to buy back stock and insider buying has been picking up.

The U.S. economy is benefitting from a few unique circumstances.  Manufacturing has experienced a bit of a renaissance as foreign corporations move production to the U.S. and domestic companies redirect some of their overseas capital back home.  Examples include Maserati and Honda who will manufacture cars in Michigan and Ohio, Rolls-Royce with its new jet engine facility in Indianapolis and Caterpillar which plans to build a new factory in Georgia.  The Asian labor cost advantage has narrowed substantially, energy costs, particularly natural gas, have declined making the added transportation costs of producing overseas less appealing.  The relative weakness of the dollar has also given domestically produced goods a price advantage.

Monetary authorities have been cutting interest rates globally.  Low interest rates should lend support to a growing economy as banks clean up their balance sheets and become more comfortable lending.  Recently, lending to small businesses has picked up.  Also, a positively sloped yield curve, as we are currently experiencing, is typically a leading indicator of economic improvement.

Market valuation also continues to be a positive both relative to historical levels and in relation to bond yields.  The S&P500 is trading at a price earnings multiple of 13 versus an average of 20 over the past 20 years.  The yield on the S&P500 is 8% versus the 10yr Treasury note under 1.9%, a record spread. 

Although the economy is healing, any of a number of roadblocks could resurface to drag growth down again, particularly with business sentiment in a very fragile state.  A key area of concern is the European debt refinancings that will be ongoing throughout the year.  If sovereign debt is replaced at reasonable rates, markets will likely be reassured.  The Greek and French elections have raised fears of an austerity backlash that will nullify the progress made in reigning in budget deficits across Europe. Europeans need to make significant progress in controlling government spending, easing constraints on labor and addressing welfare reforms or the region will have trouble climbing out of a recession and impact growth in the rest of the world.  

Growth in China is slowing to rates that approach stall speed in terms of job growth, industrial investment and consumer spending.  If growth should continue to slow, its impact would be felt in the West.  The Presidential election will undoubtedly lead to uncertainty about the prospects for the economy.  Also, the rating agencies could at any time grow tired of the pace of progress on debt reduction and further downgrade sovereign debt.  The much discussed fiscal cliff in Q1 next year may also present market challenges.  This is when the Bush tax cuts and payroll tax cuts expire as well as the sequestering of the Federal spending cuts. 

Although the market faces a number of headwinds, the evidence in total points to better growth ahead.  We will likely see further gyrations as we climb our way out of a period of sluggish growth and back to a more typical economic recovery led by strong corporate earnings, a stabilizing job market and slowly healing housing industry.

Frederick J. Linkner, CFA
Director of Research

Frederick J. Linkner, director of research, presents a comprehensive analysis of the economy including sectors, interest rates, currencies, GDP growth and how these might effect Rosenblum Silverman Sutton investment decisions.