As the first quarter of 2010 ends, the U.S. stock market is leading the developed markets of the world. Year to date the S&P 500 is up 5% and Asia Pacific rose 3.5% while European and Latin American markets have declined. In the U.S., value continues to lead growth as investors discount a recovery in the domestic economy and profits. Reflecting this support for value stocks as well as a rise in the U.S. dollar, small and mid-cap stocks have outperformed large caps.
The fundamentals for the U.S. economy continue to improve. Indeed, the U.S. appears to be the best situated developed economy in the world. Contrary to consensus views that have been calling for a sluggish recovery, the economy has been rebounding closely with historical precedent. Many indicators are following a “V” configuration compared to expectations for a more subdued recovery. The recovery is broadly based compared to past rebounds which have been largely focused upon renewed consumer spending. This time consumers are spending more than expected, drawing down their higher savings generated in 2009. It is important to note that the level of consumption has surpassed its 2008 high point. Lessening inventory liquidation has contributed to a good portion of recent overall growth. Nonetheless, inventory levels remain low and should rise in the months ahead as production continues to increase. Net exports are another source of growth for the economy.
One of the remarkable features of recent years has been better than expected productivity growth. Contrary to popular opinion, better productivity leads to stronger growth and low inflation, more robust profits growth, and increasing job creation and ultimately a lower unemployment rate. Stronger than expected productivity growth, which should be sustained in the quarters ahead, is the unsung positive force for growth that pundits overlook.
Capital spending is developing as another source of growth for the U.S. economy. Non-financial companies are generally very cash rich. While they probably will not be spending on new capacity anytime soon, capex expenditures are more likely to flow through to new technologies to further sustain productivity enhancement.
Inflation and interest rates remain low. Given the underutilization of people and plant resources, inflation is likely to remain relatively modest. Ongoing productivity gains will help. Given this outlook, the Federal Reserve is unlikely to initiate higher short term interest rates over the short to intermediate term. Nonetheless, any signs of strengthening employment and potentially stronger retail sales may start to flatten the yield curve which is historically steep for the bond market. It would not be surprising to see the Treasury bond market move above the 4% yield level if additional signs of strength are evident in the U.S. economy. The March employment numbers are likely to be one catalyst for additional weakness in the Treasury bond market. Continued large financing demand by the U.S. government is another catalyst.
The cyclical bull market in stocks, which began last March, continues to move ahead. Still liquidity driven, stock prices are becoming increasingly dependent upon improving profits to support higher levels. Given the degree of cost cutting in the past year or more, any respectable advance in revenues should lead to positive surprises on the bottom line. The U.S. stock market has become overbought technically on a near term basis. Some of the stronger components of the markets rise this year, such as small and mid-cap stocks are showing some signs of near term tops. Nonetheless, the rise in stocks this year has been broad based and this breadth is an encouraging trend for higher prices in the future. The fact that individual investors remain large holders of bonds and continue to buy bonds is potentially bullish for stocks.
Nevertheless, one should be mindful that history suggests that a meaningful market setback can occur after a major market rise, such as the 75% advance since March, 2009. Moreover, seasonal factors usually favor some sell off during the second quarter. Yield spreads have narrowed and volatility has been relatively low for stocks and bonds. Any further signs that might suggest that the U.S. economy could grow faster than now generally believed could produce increased volatility in both bonds and stocks. As a consequence, any weakness in stocks is likely to be occasioned by fear of higher interest rates. Such a setback in stocks would produce an opportunity to put more funds to work in equities.
A. Marshall Acuff, Jr., CFA
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC