By Dr Jerry Webman, PhD, CFA, Chief Economist, OppenheimerFunds
With less than a month left to go before springtime officially arrives, the US economy has yet to come out of hibernation. In fact, what’s already modest growth may even be cooling somewhat in the first quarter of 2014, based on the tone of recent economic data. How much growth may be slowing remains to be seen, but I do expect a continuation of the non-inflationary, lacklustre growth I described in my 2014 Outlook.
But if there’s an upside to uninspiring US growth and concomitantly low inflation, which keeps the Federal Reserve (Fed) on hold, even as the unemployment rate (a flawed measure of the strength of the labour market) sinks to recovery lows. The economy remains robust enough for the Fed to continue tapering its asset purchases at the current pace, but the possibility of any near-term rate hikes seems remote.
Despite some emerging market debt turbulence at the beginning of the year, investors seem to be growing more comfortable with the prospect of modest growth and a steady-as-she-goes Fed. The S&P 500 Index is within spitting distance of its all-time high, but gauges of sentiment show neither extreme fear nor excessive optimism. The same could be said for equity valuations. Nevertheless, 2014 won’t be the cakewalk for investors that 2013 turned out to be; it already isn’t.
In today’s environment, investors will have to be more selective to find real value in equities, and they’ll continue to struggle to find adequate real yields in fixed income. Although Treasury yields have climbed significantly since the lows of last year, the 10-year Treasury still only offers a yield just over 1% after inflation.
An easy Fed will keep capital looking for yield and return opportunities, and carefully favouring credit risk over interest-rate risk, in our view, remains the name of the (fixed income) game. Indeed, fund flows to floating rate senior bank loans, which historically has offered relatively high yields, and whose coupons adjust periodically to short term interest rates, have been strong so far in 2014.
Politics matters again: Thoughts on emerging markets
Meanwhile, investors who may have sought some diversification or juicier returns in emerging debt markets have since the start of the year continued to pull money out. Clearly, some investors are erroneously painting all such economies with one brush, perhaps out of fear of contagion. In recent weeks, however, markets appear to have begun sorting the stronger, more stable emerging economies from those facing more serious problems.
As I watch the events in Ukraine play out on the news, however, and as I think about brewing political and economic crises in Turkey and elsewhere, a few points come to mind.
First, past crises were not bad times to invest; they turned out to be great buying opportunities in markets not damaged by the crisis of the day. Nobody can tell the future, but emerging economies as a whole are more robust than they were in previous crises.
Secondly, governance and sound institutions matter. Investors may be tempted to overlook corruption, poor contract enforcement protections or lack of central bank independence when times are good, but when markets come under stress, investors are much more inclined to retain faith in governments that have earned a reputation for legitimacy and responsibility. Growth matters, but it isn’t everything.
Which leads me to a third point: In times of crisis, active management has the potential to make a huge difference. As a whole, the emerging world continues to grow at a far faster rate than the developed world, and probably will continue to do so for years. But for investors, blanket exposure to emerging markets—often largely through holdings in massive, state-owned enterprises—may not be desirable, especially in times of turbulence.
Active management allows us to pick and choose the exposures we want, and stay away from those we don’t. It even gives us the option to look for yield and diversification among relatively sound sovereign bond issuers, own shares in developed world companies that have substantial sales exposure in fast-growing emerging economies, and find emerging market companies that profit from the economic changes occurring in developing economies.
Finally, I’d note that with Europe still struggling to emerge from its own crisis, the turmoil we’ve seen in 2014 makes the US - soft growth notwithstanding - an attractive place to invest. As I’ve written before, I do not foresee a repeat of past emerging market crises, but as with domestic equities, investors will need to be more selective to find competitive returns and try to avoid stepping on any land mines.
Winter blues? U.S data soften
Last week brought mixed US data, with several reports showing a slowdown in the housing market. February’s Housing Market Index, which is based on a homebuilders’ survey, fell sharply to its lowest point since May 2013, as buyer traffic and home sales dried up. Separately, existing home sales fell by 5.1% in January (the fifth monthly decline in the last six months) and by the same amount year-over-year.
The severe winter weather in much of the country certainly hasn’t helped the housing market (seasonal adjustments may actually be understating its effects), but it’s not the only cause of the weakness. Relatively high mortgage rates and home prices, along with tight inventories and a soft job market are all hindering the sector.
I’d note, however, that the big move in mortgage rates is likely over for the time being, employment continues to recover and the US isn’t building enough homes every year to keep up with population growth. I would expect that as the weather warms up and buyers start looking again, we’ll see some improvement in the data.
The latest batch of manufacturing data was a mixed bag, with the regional Empire State Manufacturing survey showing modest improvement in February (albeit with weak new orders) but the Philadelphia Fed Survey essentially falling off a cliff. The Fed district issuing the report cited the miserable local weather, so let’s provisionally consider the report as more noise than signal.
In any case, a preliminary February Purchasing Managers’ Index reading released by Markit on the same day last week told a much different and more encouraging tale, coming in at 56.7 vs. 53.7 at the end of January. (Keep in mind that 50 is the threshold between growth and contraction.) The reading was the best in almost four years, and showed robust new orders, output and employment.
All told, the economy continues to chug along at a modest pace. While weather may be impeding economic activity in some sectors, which could lead to softer-than-expected GDP growth for the first quarter, the economy could make up some of that potential shortfall later on. Importantly, there’s little reason to think that US economic fundamentals are changing for the worse, and there haven’t been any major shocks to the economy that could derail the expansion though I’m keeping an eye on the deep Western US drought and its implications for the vital agricultural economy.
As the year progresses, I expect to see housing regain some strength, capital expenditures to pick up, and employment continue to improve. With inflation at bay, credit conditions becoming easier and the Fed likely to remain highly accommodative, I expect modest economic expansion to continue to help support earnings growth as 2014 progresses.
