Leo Grohowski | Chief Investment Officer, BNY Mellon Wealth Management
As the fifth anniversary of the economic recovery arrives, investors are wondering how long the expansion will last and what that will mean for the aging bull market. After a strong rally last year, domestic equity markets are stuck in a narrow trading range searching for some renewed momentum. As a result, many investors are confused about the direction of the market. While expectations are for more modest equity returns and less dispersion across equity markets this year relative to last year, there are six factors that suggest we are not at the end of this bull market. Yet the journey will certainly have some volatility along the way.
The current economic expansion has been atypical. While every previous expansion since 1949 delivered real growth in gross domestic product (GDP) of around 4% to 5%, this expansion’s annual growth has not surpassed 3% in any calendar year consistent with our expectations. Signs of improved growth are beginning to emerge, however. In the U.S., the labor market is showing signs of strength, manufacturing and services numbers are bouncing back and consumers are beginning to spend. Elsewhere, Europe’s economic indicators and corporate earnings reports are encouraging, while China’s expansion, although moderating to an annualized growth of 7.4%, outpaces that of developed markets.
Furthermore, monetary policy is usually more restrictive at this point of most expansions. However, developed world central banks remain extremely supportive of growth. The Fed is just in the midst of winding down its quantitative easing, but will likely keep rates low until mid-2015. The Bank of Japan and the European Central Bank’s bias toward fighting deflationary risk suggest that additional easing may lie ahead. Moderate growth and largely accommodative policies in developed countries should help support growth in the second half and help drive equity prices higher this year.
Multiple expansion — the value the market puts on a stock’s earnings — has accounted for most of the S&P 500 Index’s recent gains during this bull market. In fact, last year when the S&P 500 returned more than 30%, only 6% was due to earnings growth. This year, however, we expect that earnings growth will be the dominant driver of returns.
Earnings are off to a slow start, however, due to severe winter that stalled first quarter growth. As a result, bottom-up estimates for first quarter S&P earnings were trimmed ahead of earnings season. Not surprisingly, companies are beating lowered expectations and forward earnings guidance is more positive. While first quarter earnings grew about 3.5% versus a year ago, we expect the pace of profit growth will pick up as the year progresses. Second quarter earnings are expected to rise about 6% according to consensus estimates, followed by more than 10% in the second half of the year. This would result in an annual earnings growth rate of roughly 8%, which is near the midpoint of our S&P 500 earnings estimate for the year of $115 to $120.
Corporate profit margins are one driver of equity market performance as illustrated in Exhibit A. Following the financial crisis, companies took steps to reduce costs, deleverage existing debt and improve balance sheets and margins. While these steps have resulted in profit margins near all-time highs, there are a few environmental factors that should also support margins going forward.
S&P 500 vs. S&P 500 Net Margin As of 3/31/14.
Companies are using high levels of free cash flow to pay down debt and take advantage of low interest rates by extending the duration of debt. Lower tax rates on earnings generated abroad have also lifted after-tax margins and faster growth in those markets should gradually drive tax rates lower. Wage growth can pressure margins but that has not been the case during this recovery and the relatively high level of unemployment should keep that risk at bay for the next few years. In addition, pricing power for goods and services has started to improve due to a better economy and should help support margins over the next few years.
Capital spending — investment on equipment, technology or growth initiatives — has been low during this recovery as businesses worried about lingering policy uncertainties and the tepid pace of the recovery. Now that confidence in the expansion is gaining traction, companies are beginning to take advantage of the high level of cash balances and access to inexpensive financing to invest in their businesses as illustrated in Exhibit B.
Percent Planning Capital Expenditures Next 3 to 6 Months
As of 3/31/14. Seasonally Adjusted 3-Month MA. Source: National Federation of Independent Business and Haver Analytics
Furthermore, capacity utilization—or the level to which the productive capacity of a plant or company is being used in the generation of goods and services—has also been rising since the crisis and is approaching 80%, which historically has been a threshold for accelerating capital spending. Add to that, aging fixed assets and equipment and we will likely begin to see a pickup in business spending. This should bode well for the S&P 500 Index given the positive correlation it has with the level of capital spending. The technology, industrials and materials sectors, which typically account for 40% of S&P 500 revenues, would be direct beneficiaries of any pickup in capital spending.
M&A activity has been gaining momentum over the past year, as illustrated in Exhibit C Deals through the end of March totaled more than $250 billion, with most coming from the healthcare and telecommunication sectors. The pickup in deals is not surprising given the $1.3 trillion in cash held by S&P 500 companies at the end of last year.
Number and Value of U.S. M&A Deals, Quarterly
As of 3/31/14. Source: StrategasRP.
A surge in corporate deal activity is typically positive for stocks and a sign that corporate confidence is on the rise. Shares of companies being acquired have jumped an average of 18% while those doing the buying have increased on average by 4.6% to date. The acquirers’ stocks are moving higher in anticipation of faster earnings growth driven by revenue synergies and cost cutting opportunities. Thus, in this slow growth environment, mergers and acquisitions are another way that companies can boost their profits.
While we anticipate that price/ earnings ratios (P/Es) will be driven mostly by earnings this year, a muted inflationary environment is typically favorable for modest multiple expansion. Inflationary pressure can negatively impact P/Es, because a surge in inflation typically means that the Fed will begin to increase rates. As depicted in Exhibit D, U.S. inflation is currently under 2%, suggesting that P/Es still have some room to run. Core inflation in many developed markets remains muted, suggesting that there is little evidence of cost pressures building. In addition, the softness in China’s Purchasing Managers Index suggests that commodity prices are likely to remain subdued.
Average S&P 500 P/E by Inflation Rates (1950-Current)
As of 3/31/14. P/E: Last twelve months. Source: StrategasRP.
Although stock valuations are no longer inexpensive, we still believe they are fair. Based on these factors, which we expect will be positive drivers of earnings growth, we remain confident that equities can end the year higher. While the VIX, a closely watched gauge of investors’ fear, remains relatively low, it has been masking a fair amount of volatility occurring within the market. Over the last few months, there has been a rotation out of high-valuation ‘momentum’ stocks that led the market in 2013 into value-oriented names.
Small capitalization stocks have also lagged large caps. While this underlying volatility has been unnerving, this type of rotation is not uncommon at this point in a market cycle. Thus, investors should expect additional choppiness near term.
Finding opportunities will prove more challenging, however. As we’ve seen so far this year, the market will not lift all stocks as it did last year. Thus, selectivity will be critical and require an active, bottom-up approach to uncover securities that are still reasonably priced, possess sound fundamentals and offer long-term growth potential.
Consistent with an improving economy, above market earnings growth is expected this year from companies in more cyclical sectors including materials, technology, consumer discretionary and industrials. In addition, an increase in capital spending in technology segments such as cloud computing, software and services companies, and equipment upgrades, should be positive for technology and industrial companies overall. Many companies within these sectors have the potential to increase dividends over time as well. With payout ratios still historically low and an abundance of cash on corporate balance sheets, those companies that can grow their dividends over time can offer potential appreciation as well as an important source of income in today’s low yield environment.
We expect equities to outperform bonds and advocate diversification across capitalization and geography. We favor domestic equities and large cap stocks, in particular, but believe there are reasonably priced opportunities outside the U.S. as well. Companies appear attractively priced in developed international markets and offer renewed growth opportunities, especially in Europe. Emerging market equities have stabilized since the selloff early this year and continue to offer differentiated but compelling growth prospects for investors with a longer term horizon.
Despite the volatility and modest gains year to date, these six factors support our positive expectation for equities versus other asset classes in 2014. While we anticipated volatility to be more prevalent this year, we continue to monitor geopolitical tensions and other macroeconomic developments but expect that these risks may be short lived and not impact our longer-term views. Still it is important to incorporate diversifiers that are less correlated to traditional asset classes in order to help smooth out any bumps along the way. In the end, an active, disciplined approach to investing can uncover opportunities and add value to a well-diversified portfolio over the long term.
This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.