In spite of the threat of rising interest rates, the US stock market has enjoyed a robust rebound after last summer’s fears of a double dip recession. The economy’s slow mend has played a minor role in the market’s recovery. The important factors affecting equity performance have been threefold: 1) Corporate profitability, as measured by profit margins, has been at historically high levels. In some cases, we have even seen revenue growth. 2) The Federal Reserve’s second round of asset purchases, Quantitative Easing (QE), was announced at the end of August and has introduced $17 billion of liquidity through asset purchases. This $600 billion program is scheduled to end in June. 3) The extension of the tax cuts, which were due to expire at the end of December, both removed a significant market uncertainty and introduced a new form of fiscal stimulus by reducing payroll taxes and adding accelerated depreciation benefits. In addition to not raising taxes, these reductions are providing $100 billion temporary boost to consumer spending (through the payroll tax reduction) and corporate profits (from accelerated depreciation).
The improvement in the stock market has improved animal spirits, one of the stated aspirations of the Fed Chairman. Higher consumer confidence leads to higher retail sales and the promise of broad economic recovery. Yet, many problems remain. Residential real estate is likely to continue under pressure as more properties come up for foreclosure. Continued budget measures in states and municipalities and modest fiscal restraint at the federal level are likely. Small steps taken now to reduce the trajectory of mounting debt service requirements in the future will nonetheless be a headwind the market will face in the near term. As we move into spring, we will all be wondering what the Fed will be doing when the asset purchases associated with QE 2 expire in June. Since we do not expect significant improvement in the employment picture, it is unlikely that the Fed will start retiring all the debt as it matures. However, a renewed asset purchase program at the level of QE 2 is unlikely, and certainly not immediately. It is worth noting that the interval between the expiry of QE 1 in March of 2010 and the announcement of QE 2 at the end of August 2010 was tempered by a lackluster stock market (down 9.5%).
We have seen some pretty high estimates for GDP growth for this year and next. Typically, after a major credit crisis and high debt to GDP, economic growth remains subdued (Google: Reinhardt and Rogoff). Slow economic growth makes the economy vulnerable to shocks, potentially leading to a recession. There are many potential sources of shocks (take your pick), some we know about and others will become obvious after they have occurred. We will probably learn to live with shorter business/ economic cycles.
Outside of the United States, rising food, energy, and real estate prices have encouraged some important economies (Australia, Brazil, China, and India -among others) to increase short-term interest rates. International inflation fears may put pressure on some emerging markets, but are not of immediate concern to the United States. Yet, rising commodity prices are likely to affect margins for consumer staples and consumer discretionary stocks. We favor areas where there is pricing flexibility, namely in agriculture and energy. And, investing in the technology cycle certainly remains very interesting.