’Tis the season of the wonderful milestone of graduation, that rite of passage that marks a transition from one stage in a student’s life to another. Beyond all the pomp and circumstance, the caps and gowns, the boozy celebrations and maudlin speeches, graduations challenge us to shift beyond the preparation and anticipation of a contemplated destiny to embrace the living of its reality.
In many ways, the global economy and markets are experiencing a graduation of their own in 2014, from the anticipation of recovery from the depths of the Great Recession to the realization that we have now moved well beyond that fateful time. Supported by the juice of unprecedented monetary policy easing, equity markets, true to their forward-looking nature, anticipated an economic and earnings recovery some time ago, allowing many markets to achieve record highs since 2008.
Today, in 2014, that momentum is being tested some, now that we have actually graduated to the growth environment we anticipated. In our postgraduate life, market action is likely to be more volatile, oscillating between triumphant realization of milestones achieved and worried uncertainty. We continue to grapple with issues such as high unemployment and subpar growth, legacies of our past that could become structural problems rather than just cyclical overhangs.
Ultimately, as all graduates soon learn, success in the real world depends on the value you provide other people and organizations. Companies will likewise need to differentiate themselves with revenue and earnings growth. Countries will have to show economic leadership above and beyond their liberal application of monetary policy.
Fundamentals will matter again, making for a more nuanced environment sure to put investors to the test.
U.S. Will Return To The Head Of The Class
After a tremendous acceleration in 2013, the U.S. economy’s stall to a mere 0.1% annualized growth rate in the first quarter has raised doubts about the sustainability of our domestic recovery. To be sure, an unusually severe winter froze fragile consumer sentiment, capex and housing-related construction. GDP growth was also restrained by payback from a buildup in inventories in the third quarter of last year, not to mention a slowdown in exports thanks to difficult shipping conditions and weakness overseas.
While it may seem cavalier to dismiss Q1 U.S. economic weakness as isolated and unimportant to the long view, investors have been wise to not cast so gloomy a verdict, allowing stock prices to remain resilient, if not range-bound. That view is being supported by notable improvements of the data in recent months, including a return to healthy consumption as evidenced by the rebound in retail sales in March, which were up 3.7% from a year before, not to mention a recovery in vehicles sales now running at a 16 million annualized sales rate. By April, job creation had also reaccelerated, durable goods sales were on an upswing, and industrial production, which shrank in January, rebounded in February and March.
Unfortunately, the housing market’s loss of momentum seems more than just a transient weather-related occurrence, as limited supply and declining affordability are restraining activity. Another ongoing challenge is the trend of flat wage growth, which has restrained more buoyant consumer spending. On the corporate side, U.S. firms remain tentative about expanding their business and are holding back on investments.
And yet, first-quarter earnings trends were surprisingly strong, especially given the sluggish economic backdrop in which they were generated. By early May, with 89% of the S&P 500 reporting, earnings for large-capitalization companies gained a solid 5.2% on average, which was driven by revenue growth of 2.4%. Small and midsize companies were more impressive, showing revenue gains of 6.7%, which lifted earnings 10.2%.
Looking ahead, the second half of 2014 should see a return to a more normalized growth rate, with all weather-related impacts reversed. Pent-up demand for capex spending on information technology, the build-out of infrastructure to support the shale revolution and increased construction related to the housing recovery could be among the catalysts for more robust jobs and revenue growth and may drive market momentum forward from its current sideways malaise. But the pace will be that of a marathon, not a sprint.
Since current valuations of many U.S. companies already reflect normalized growth conditions, the outlook is necessarily for only average overall returns. There is also likely to be an ongoing short-term vulnerability to external shocks resulting from uncertainties such as the U.S. midterm elections, evolving Fed policy in a post-QE world and geopolitical risk (in Russia and the Ukraine, etc.). Investors should focus on the idiosyncratic risk and reward factors of sectors and companies, since lower correlations among these in a more nuanced investment environment could lead to an increasing dispersion of returns that will create opportunities for skilled stock pickers.
Developed International Economies Are Most Likely To Succeed
While overseas developed markets have offered a mixed bag of returns in 2014, these markets have attractive valuations on their side and the prospect of additional monetary policy action in the wings to drive their outperformance. Recovery has been confirmed, with the U.K. and “core” European countries on the rebound, and even the weakest links from the euro crisis, such as Spain, Italy and Ireland, seeing an uptick in growth. Confidence is on the rise, which is pulling up retail sales and auto registrations across the region. In April, the composite purchasing managers index for the euro zone rose to its highest level in almost three years, indicating a pickup in manufacturing activity. Yet there have been some headwinds, including an appreciating euro that has translated into somewhat lackluster topline results for European companies, as well as the ongoing deleveraging activity of European governments and banks in the wake of the sovereign debt crisis.
Grappling with low inflation and a strengthening currency, European Central Bank chief Mario Draghi has telegraphed that policy in the euro zone will be loosened in June, which may be a major catalyst for European equities here in the second half of 2014, depending on how far he goes.
Likewise, the Bank of Japan seems poised to shower more liquidity upon its markets, as it seeks to offset the impact of the consumption tax increase that went into effect in April. Despite positive recent trends in improving consumer income, wage growth and inflation, underlying demand will be impaired given the sales tax increase. There are also concerns that the decline in the yen has failed to stimulate exports. Given the context of Abenomics (the fiscal and monetary package named for Japan’s prime minister), it is unlikely Japanese leadership will sit idly by when future growth is at stake.
Emerging Markets Will Struggle To Make The Grade
While the EM currency crisis that opened 2014 has receded, other risks have since emerged, including escalated tensions among Russia, Ukraine and the international community. The potential for a significantly negative long-term impact from this political and military crisis seems limited, so long as the situation does not devolve and cause the interruption of gas supplies to Western Europe or a breakdown in world trade.
For now, the biggest risk to the EM complex remains China’s progressive slowdown in economic activity as the country’s policymakers seek to curb its credit expansion. Fears of a systemic credit crisis are likely overblown, though, since the Chinese economy has a huge savings rate (about 50% of GDP) and international reserves of $3 trillion. Even so, selected instances of distress and default are inevitable and will continue to be difficult for investors to calibrate, especially in the short term. Nevertheless, China remains determined to carry out its agenda of ambitious structural reforms, since these measures will ultimately improve the overall quality of its economy.
These overhangs, among others, will make it difficult for emerging market equities as a whole to take off in 2014, though in many cases fundamentals are solid, valuations are cheap, and profit margins have room to surprise on the upside. One near-term catalyst may be upcoming elections and the belief that new reform-minded governments will ultimately lead to better investment climates. But emerging markets may be a lonely trade for some time, and one best suited for the long-term investor.
After five years of investment success predicated on macro prudential policy outcomes, a graduation to the real world of fundamental investing is a paradigm shift sure to create disruption, and opportunities, for those willing to embrace it.
Michelle Knight is chief economist within the Private Client & Wealth Management practice of the international law firm Ropes & Gray. This article contains the current opinions of the author and should not be considered as investment advice or a recommendation.