We figure if Hollywood can produce "Rocky V" and "Fast and Furious 6," we can at least come out with "Noise 2." My last economic update was entitled "Noise." Given the amount of new material, we expected to come up with something more unique to describe the economic and investment environment. As investment managers, however, the amount of noise has become almost too much to bear.
One of the noisiest domains includes the U.S. Federal Reserve. Last May, the Fed threw down the gauntlet and projected an eventual reduction to its quantitative easing program. This program involves the purchase of long-term U.S. Treasury notes and mortgage-backed securities in an effort to keep long-term interest rates low. These low rates were expected to entice people to buy homes and businesses to purchase equipment, resulting in economic growth.
In September, the Fed surprisingly backed away from its plans and kept the spigots open. We have to admit, this change in direction was confusing. It is similar to uttering the four most-feared words in a relationship: "We need to talk," followed by: "Never mind." Investors went through all of the stages of grief (denial, anger, bargaining, depression and acceptance) only to be questionably placated by the Fed's admission of an economy too weak to handle tapered quantitative easing.
The resulting noise was almost deafening. It included admonishments directed toward Federal Reserve Chairman Ben Bernanke and his Board of Governors, as well as much speculation as to when the Great Taper will actually begin. Possibilities range from as early as October 2013 to mid-2014. The admonishments give us pause. Ben Bernanke is no lightweight, and he is supported by legions of highly educated economists and statisticians. Surely his concerns must have merit.
Well, Shirley, we are not so sure. As much as we hate to admit it, we have to wonder if this decision is not part of a plan to retire with honor and let the next guy clean up the mess. The stated reasons for continued quantitative easing centered on weak U.S. employment. As we have written in several past issues, the labor market recovery has been less than robust. Recent reports from the Bureau of Labor Statistics revealed an average monthly job gain over the last three months of 148,000, which was the lowest pace so far in 2013. The labor force participation rate was 63.2%, for a new post-recession low.
Trouble is, these headline numbers are lagging indicators, and they often overshadow more leading details in the monthly reports. For example, the report for August indicated an impressive gain of 118,000 full-time jobs. The number of people involuntarily working part-time dropped by over 300,000. When the many layers of the employment onion are peeled back, we see a picture of steady improvement. Yes, you heard right. We believe the labor market is strengthening.
We find encouragement in recent initial claims for unemployment, which are reported on a weekly basis. These claims are a leading economic indicator, and over the past six months they have fallen at an annualized pace of 27%. At 305,000, the level of initial claims filed for unemployment benefits is at a six-year low. Say it with us, "A six-year low."
There has been much hand-wringing about our low labor force participation rate. One discouraging element of this statistic involves young people. Many are staying in school because they see few job opportunities. One reason they do not see opportunity is retiree-age baby-boomers are hanging on to their jobs. According to Pew Research Center®, the age 64+ segment of our population shows a net increase in employment over the last several years.
According to research from the International Statistical Institute (ISI), the International Labor Office is forecasting annual growth of the developed world's labor force of only 0.18% in this decade. The U.S. will account for almost 105% of that growth.
Still, many retiree-age baby-boomers are exiting the labor force and enjoying the good life. More may choose this route once they open their 401(k) statements. Choosing the good life automatically depresses the labor force participation rate as does the decision by young people to stay in school.
Now let's think about this. Despite the cosmetic industry's all-out war on aging, no one yet has figured out how to stop the clock. Working retiree-age baby boomers will continue to age. They will eventually exit the labor force (one way or another). At about the same time, educated millennials will finally graduate and be ready to enter or re-enter the labor force. They have time on their side.
Thus we see an undercurrent of improving employment conditions coming our way. According to research from the International Statistical Institute (ISI), the International Labor Office is forecasting annual growth of the developed world's labor force of only 0.18% in this decade. The U.S. will account for almost 105% of that growth. Germany and Japan will see a declining work force and account for -16% and -21% of that growth, respectively. A young educated work force will greatly contribute to our nation's long-term economic growth. This is good noise!
Noise bounces off the ceiling
Unfortunately, some very unpleasant noise now surrounds us. It emanates from Washington, D.C., and it feels like déjà vu all over again. We seem to be headed down the same path as in August 2011 when the debt ceiling was breached and our country's credit rating was dropped. It was not a good time for investors, and we expect current conditions to become noisier before we get resolution.
During the writing of this report, the first U.S. government shutdown in 17 years began. Each year, about one-third of the federal budget requires authorization from Congress. There has been so much feuding about this year's authorization it makes Donald Trump and Rosie O'Donnell look like best friends forever. One question is just how long this shutdown will last. The more important question involves the mid-October debt ceiling debate and what the resolution will look like. All of this noise will contribute to a rise in stock market volatility. The fact we have been there and done that (in 2011) may offer small consolation.
After the stellar 18% rise in the S&P 500® this year, we will not be surprised if that volatility results in a market correction. We do not, however, believe a correction will suddenly turn into a bear market. Rising business confidence, the gradual improvement in the labor market and the recovery of household net worth to new record highs all support our optimism.
Profits ring loudly
Another reason we believe the environment is positive for stocks is the ongoing improvement in corporate profitability. Despite all of the noise and the uncertainty it produces, corporate earnings have continued to surprise on the upside. This is what investors should listen to! Recently reported overall U.S. second quarter corporate profits grew at a 16% annualized pace and were 5.4% ahead of last year's level for the best pace of growth in three quarters.
This profit growth bolsters our belief in a strengthening labor market. It also supports continued improvement in capital expenditures and business investment. Like most of our economy, this trend has had its fits and starts, but there are signs of staying power. One of the most accurate assessments of planned spending by business is the core capital goods orders index (nondefense capital goods excluding aircraft). This activity gained 1.5% in August, and its three-month annualized pace of growth is an impressive 8.4%.
Other measures of business spending reflect improvement as well. The Federal Reserve Bank of Richmond's survey showed capital expenditure plans doubling in September and sitting at a 13-year high. The Federal Reserve Bank of Kansas City's survey showed manufacturers' sentiment improving significantly with new orders, production, shipments, employment and workweek all registering substantial gains.
As an investment advisor, diversification is etched upon our minds. The measures of activity mentioned above are especially encouraging to us because they are driven by diversified sources of growth. In addition to our own recovery, U.S. companies are now beginning to feel the effects of an improving European economy. The Institute for Supply Management™ survey of manufacturers showed better than expected export activity, supported by both the euro zone and the United Kingdom. Together, these markets represent our second-largest export market. The euro zone's real Gross Domestic Product (GDP) is expected to grow about 1.7% in 2014 compared to slightly negative growth in 2013.
Japan's return from the dead will also support U.S. economic growth. Prime Minister Abe's growth-oriented policies are gaining traction. The Japanese economy is expected to grow about 2% in both 2013 and 2014 for the first period of back-to-back growth in years. And, despite numerous calls to the contrary, emerging economies are showing signs of life. China's 2014 economic growth rate is expected to be even with 2013 growth at about 7.5%. Brazil and India are also now beginning to benefit from their central banks' tap on the brakes earlier this year. That tap moved these economies from the risk of overheating to an arena of sustainable economic growth.
The din of the stock market
There are always reasons to hold back from participating in the stock market. Investors who contemplate an increase in their allocation to stocks typically take money from something safe such as a bank account or a matured certificate of deposit (CD). It is scary to leave something safe and comfortable for what feels like the unknown, especially with so much noise from Washington, D.C.
Although that noise could reach deafening decibels for a while, remember it is just that — noise. Meantime, there are solid underpinnings to economic growth that lead us to emphasize U.S. stocks in client portfolios. While not exactly a "blue-light special," the U.S. stock market is reasonably priced at about 14.6 times earnings over the next twelve months. This compares to the 10-year average of about 14.0 times and the five-year average of about 12.9 times. It means investors are willing to pay $14.60 for every $1 of company earnings.
Considering the alternatives and the underlying economic conditions discussed above, that price strikes us as fair. One way to come up with an even fairer price, of course, is to look for stocks of companies with earnings that are undervalued by the market. Mutual fund managers who do the same could also have a place in an investor's portfolio.
As long-term investors, we will typically have a presence in small company stocks in our portfolios. This sector has regained its popularity in 2013 after a two-year sabbatical. In fact, the Russell 2000® Index of small company stocks is up over 26% through the end of September. Investors who need to take some risk off the table may find opportunities to do so in this arena.
Meanwhile, we believe balanced investors should continue to have some presence in foreign markets. The fear of collapse in emerging markets has been overdone. What is happening, however, is the developing world is becoming less homogeneous and more multifarious. This may lead to foreign emerging market mutual funds with active managers outpacing pure index funds.
The buzz on bonds
While we suggest an emphasis on U.S. stocks, this does not mean an avoidance of bonds. We are all about balance, remember. Our bond portfolios, however, are becoming even more prepared for a rising interest rate environment. In our opinion, the continuation of quantitative easing means a longer time of distortion in the financial markets. The Fed has chosen to delay the inevitable, and this raises the risk of much higher interest rates down the road.
Speaking of distortion, we continue to find fixed income opportunities in the municipal bond market. This market has suffered from the distortion of the "Detroit effect" as investors continue to digest information related to its bankruptcy. Municipal bond yields are attractive even for accounts not subject to income tax. Quality (as measured by the ratings agencies and our own research efforts) remains key here.
Additionally, believe it or not, there is a whiff of inflation in certain areas of the economy. Remember our mention of the Federal Reserve Bank of Richmond's survey? It included a measure of prices paid by manufacturers, which increased to an 11-month high of 2.44 compared to 0.99 in August. The measure of prices received by manufacturers hit its highest level since November 2011.
Interestingly, given our lengthy discussion of the labor pool and the non-economic reasons for the declining participation rate, it should not be surprising that annual wage inflation has bumped up to 2.2% from 1.3% a year ago. Inflation remains extremely low, and its emergence is a long-term development to be sure, but we are taking note and continuing to keep our bond portfolios short.
The U.S. economy is on solid ground supported by a slow, but steadily improving labor market. While not without challenges, this economic growth will go a long way in resolving investor uncertainty across the globe. How do we make it go even further? According to The Economist®, economic growth nurtured by capitalism and free trade explains how global poverty was cut in half between 1990 and 2010. Two-thirds of poverty reduction is the result of growth. One-third is the result of greater equality of income distribution. A one-percent increase in income contributes to a 4.3% reduction in poverty in the most equal countries. That same one-percent increase only yields a 0.6% reduction in poverty in the most unequal countries.
This difference in the multiplier effect is huge but frustrating because so much of the situation feels beyond our control. The good news is we have more control than we might think. We can commit to being a mentor to today's youth to ensure their future participation in the labor force. We can volunteer to help people learn to read. We can encourage nonprofit organizations to devote resources to job-training programs for disadvantaged youth. Anything we can do to help people land a job will contribute to economic growth. As an added bonus, this economic growth will help silence the noise coming from Washington, D.C.
Information deemed to be accurate as of October 21, 2013. All registered trademarks and service marks are the property of their respective owners.