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The U.S. an Oasis in a Global Sea of Problems - Royce Funds Commentary
Posted by: Holly LaFon (IP Logged)
Date: February 19, 2014 10:23AM
Despite the ongoing political and economic uncertainty in the emerging markets and a slow start for stocks in 2014, Portfolio Manager and Principal Charlie Dreifus believes the U.S. economy is in good shape going forward.
In January, generally weak economic news and data coming out of China gave momentum to the declines in emerging markets. Obviously, given the strong gains last year in the U.S. stock market, this news also served as a handy excuse to take profits. Right now, the recalibration regarding emerging markets has resulted in Mr. Market demanding higher returns given the high risks.
However, politics may get in the way of emerging market central banks continuing their tightening, and thus slower growth, as elections loom in India, Indonesia, Brazil, and Turkey. Stagflation is common these days in the emerging markets and could take quite some time to eliminate.
Contrary to almost all investors' expectations, including ours, the market declined significantly in January while bond yields fell sharply. The primary causes were emerging market turmoil and the U.S. economy losing some steam. Some companies reported earnings that were disappointing to many investors, though generally not to us.
For the economy, our belief is it may merely be the cold, snowy weather to which much of the U.S. has been subjected, though it will take time to tell for sure. The U.S., despite the current turbulence, is in the best shape vis-à-vis the alternatives. Our trade and budget deficits are shrinking, and our GDP growth is solid. The measured pace of tapering by the U.S. Federal Reserve should be completed by the end of 2014, leaving forward guidance as the main policy tool of the Fed.
The incremental margin thesis continues to intrigue us, particularly when most are saying that margins are too high and must revert to the mean. Interestingly, margins for the S&P 500 increased in the fourth quarter of 2013 on both a year-over-year and quarter-over-quarter basis. Part of this was due to constrained labor costs and technological innovation. All this results in our belief in lower break-even points and thus higher operating margins—indeed much higher margins—once revenues advance more quickly.
In the past two quarters, the U.S. economy grew at its fastest pace since 2003. We saw a strong preliminary fourth-quarter real GDP report, which pegged the economy rising at a 3.2% annual rate. The fourth quarter included the U.S. government shutdown. Strength was present in consumer spending, investment, and trade. Removing government spending and thus looking only at private real GDP, the economy rose at a 5.1% annual rate in the fourth quarter.
Inventory rebuilding in the fourth quarter continued, surprising most forecasters. We had previously pointed out that this was possible, stemming from historically low inventory-to-sales ratios. In fact the broadest ratio, "non-farm inventories to final sales of good and structures" in constant dollars, set a 40-year low in the fourth quarter. Real consumer spending rose at an annual rate of 3.3% in the fourth quarter, the fastest increases since the fourth quarter of 2010.
Given persistently low inflation, the Fed will not be raising interest rates for quite some time. It seems likely that, once we break through the 6.5% unemployment rate threshold on a continued basis, the Fed will abandon that figure for a lower one, with the labor participation rate held up as the excuse. This will be supported by some evidence that the drop in the unemployment rate is structural and not cyclical. The drop in the labor participation rate is not a function of discouraged workers but rather a secular issue due to aging Baby Boomers.
The Fed underweights high-frequency events in favor of longer-term macro issues. It also underweights international items unless there is a direct effect on the U.S., and even there the reference point is its impact on U.S. household wealth and spending. It is true that, if emerging market events cause either economic or financial stability risk to the U.S., the Fed might act.
One byproduct of the inexpensive financing provided by the rescues of 2008-2010 is that it prolonged the life of marginal firms, adding to the physical volume of production and therefore to the weight on prices. Debt is deflationary to the degree that it promotes production. Despite deleveraging, central banks still worry about declining prices as they boost the real burden of indebtedness.
As a result of the lousy job market, heavy student debt, and the unwillingness of banks to make loans, household formations have declined. There is a huge potential here for growth if these issues can be favorably resolved.
Obviously should the recent weaker data points in the U.S. prove not to be weather related, and thus persist, that could become a problem. Tapering combined with weaker economic data is likely to be bad for the equity market.
With fiscal policy shifting to roughly neutral in 2014, the drag from declining federal spending is likely to abate. The federal budget deficit will fall below the 3% GDP threshold in fiscal year 2014. If the economy and stock market hold up and tax receipts grow modestly, it is possible that we will see a budget surplus in a year or two. Federal outlays have been basically flat for almost five years. And the U.S. is seeing tax receipt growth.
Some have described the combination of Janet Yellen as Chairperson of the Fed with Stanley Fischer as Vice Chair as a dream team, with Fischer adding international expertize that Yellen can draw on.
While having retreated, the market remains elevated. However, we remain bullish as we still feel our positive outlook thesis is still relevant. We think that consumer strength is likely to continue as a result of pent-up demand, demographic trends, employment growth, healthier balance sheets, and lower inflation. (The 10-year U.S. Treasury note declined from 3.01% in early January to 2.65% at the end of the month.)
Profits for the fourth quarter seemed legitimately solid and thus re-enforce our incremental margin thesis. This does not, however, disabuse the notion of management's need to manage expectations. If one sets the bar low enough, results will likely look good. The government shutdown, for example, was one excuse offered for modest expectations.
As we mentioned earlier, inflation is probably more critical to the Fed changing course than unemployment. The central bank focuses on the Personal Consumption Expenditure Deflator. The Fed is aiming for a 2% rate as a threshold before considering raising rates. The latest figure is 1.2%. For now, and the intermediate term, this does not seem to be a worry.
Our outlook is still positive. The U.S. is an oasis in a global sea of problems, essentially independent of other nations. In addition, we have a growing population, a more laissez-faire economic system, rule of law, plentiful inexpensive energy—indeed, an energy renaissance—a manufacturing renaissance, and within a few years, we believe, balanced budgets—both trade and fiscal.
Higher natural gas prices, caused by severe winter weather, were part of the recent pullback in equities. The good news is that milder weather should eventually restore both gas prices and equity multiples.
The market contagion we have seen has really been within the emerging markets, and not between emerging and developed economies. Domestic economic data points have been quite steady given all that has occurred. The glass half full interpretation of this would be a Goldilocks view. As the creation of the U.S. Congress, the Fed is legally bound to focus on the U.S. It will not function as the global central bank.
Much talk has recently been about hedge fund activism. Remember, it can occur elsewhere. Some time ago we highlighted that none other than Ralph Nader, the man who was the nemesis of General Motors regarding car safety, lobbied as a shareholder of CISCO for them to pay and increase dividends. The world has changed—shareholders large and small can be a cause for better capital allocation at companies.
From 1950 forward, the average trailing 12-month P/E for the S&P 500 has been 17.9x when inflation is between 0 and 2% and 17.2x when inflation was 2 to 4%. Therefore, while not table-poundingly attractive, valuations do not yet appear to be in bubble territory.
Charlie Dreifus is a principal and portfolio manager of Royce & Associates, LLC. Mr. Dreifus's thoughts and opinions in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. No assurance can be given that the past performance trends as outlined above will continue in the future. There can be no assurance that companies that currently pay a dividend will continue to do so in the future.
The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
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