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FFT News

 2015 Economic Outlook Q2

April 23, 2015



  • First quarter earnings weaken due to the strong dollar, bad weather, and a decline in the energy sector
  • Interest rates remain low in general, but the Fed may raise short term rates by year end
  • Opportunities exist in international markets as central banks act to stimulate growth and economic conditions improve in the euro region
  • A more market neutral approach may be warranted until visibility improves

A Shift into Neutral

Despite some significant volatility in the first quarter, the markets continued their upward trend into 2015. Below is a scorecard through the first three months of the year. The S&P 500 managed a slight gain and interest rates remained low despite some early chatter regarding the Fed. After a rough 2014, international markets played catch up, from both a return and policy standpoint as the European Central Bank (ECB) launched their own widely anticipated quantitative easing program. This led to a near 5% return in developed international markets. On the flip side, commodities continued their slide into the new year. The question remains - where do we go from here?
At the beginning of the year, we pointed out that the market would likely be driven by earnings growth from this point forward. Given all of the downward revisions to expectations, it seems reasonable to assume the market may be in for a pause. Coming into 2015, analysts on average were expecting 2% growth in earnings for the first quarter. As the reporting season kicked off in early April, expectations had shifted dramatically down to an anticipated drop of over 5% in earnings. The primary reasons for the negative outlook were attributed to sharp earnings declines in the energy and materials sectors as well as the impact of a stronger dollar. While the energy sector is certainly feeling the squeeze, the silver lining is the fact that other industries are benefitting from the lower input costs, which in turn leads to improved margins. The strong dollar has hurt our competitiveness overseas and led to fewer dollars being translated back to U.S. balance sheets from multinational corporations. To date, earnings have been a mixed bag, but for the most part have actually come in ahead of some very low expectations. Despite the bump in the road, we still expect earnings to grow in the mid single digits range for the year. The primary driver of this growth will be the U.S. consumer, who continues to be bolstered by a (gradually) improving job market, higher wages, a strong housing market, lower energy prices, and continued low borrowing costs. On that last point, debate continues on just how long that will last.
Despite some early predictions that the Fed was on the verge of raising the benchmark interest rate, we still see no cause for them to act. For one, the economy, while expanding, is still experiencing some growing pains. For every two steps forward, there seems to be a step back. The March jobs report was particularly bleak and record snowfall in the northeast certainly did not help. As it stands, analysts are expecting year-over-year GDP growth of 1% in the first quarter, down from 2.2% in the fourth quarter of 2014. The strength of the dollar has been of particular concern for the Fed and raising our interest rates now in the face of lower global yields would only compound the issue. With the launch of the ECB's quantitative easing program and fear of deflation, interest rates overseas continue to grind lower. In fact, Switzerland became the first country to issue 10 year debt at negative yields. With that said, we still think the Fed may make a move before year-end. The reality is when the starting point is zero, the Fed can afford to raise rates slightly and have little meaningful impact. Ultimately, we feel the Fed is somewhat anxious to return to a more normalized policy and to show they are being proactive.
Continuing with the international theme, economic activity in Europe continues to improve, benefitted by the lower euro, low oil prices, and a central bank cash infusion. A measure of services and manufacturing activity in the region picked up significantly in the first quarter following some November lows. Hiring by employers also accelerated to the fastest pace since 2011, helping lift consumer confidence in the region to levels not seen since 2007. Fourth quarter GDP growth of 0.3% beat expectations, and it appears the first quarter of 2015 will likely surpass that. Despite the positive momentum, Greece remains an overhang as they continue to haggle over a bailout deal with their creditors. At some point, Greece will either agree to certain reforms, or drop the euro. While this back and forth will continue to weigh on markets, a resolution could actually be positive, regardless of the outcome. Shifting the international focus to China, investors are encouraged by the move from the government to throw its hat into the stimulus ring. For the second time this year, the People's Bank of China (PBOC) lowered the reserve requirement for all banks in a bid to boost lending and combat slowing growth. This comes on the heels of two interest rate cuts since November. We recommend investors take advantage of increased stimulus across the globe and the economic recovery in Europe by increasing allocations to both overseas markets.
To summarize, the old adage, "Sell in May and Go Away" may actually fit this year from a short-term timing standpoint regarding U.S. stocks. With a drop in corporate earnings and revenues, some weaker economic numbers, and money flowing into overseas markets, a correction seems plausible. At the least, it's hard to envision a significant move higher in the face of those headwinds. Markets may simply tread water until the outlook improves. With that said, we are not suggesting people run out and sell stocks. A well constructed portfolio with diversification across multiple asset classes should help portfolios withstand any short-term hiccups. We suggest using any weakness to rebalance and reposition for the long term. In fact, after providing a bit of a drag to portfolios benchmarked to the S&P 500 over the last couple of years, diversification is paying off once again. As illustrated earlier, the S&P 500 was outperformed in the first quarter by every other asset class listed, outside of commodities. Overall, we believe things will pick up after the slow start to the year and we continue to favor stocks for the long term. Despite the earnings pause, corporate balance sheets are still strong and the economy is improving. Look for increased stock buybacks, higher dividend payouts, and increased M&A activity to support stock prices. Until things become clearer however, avoid any major sector bets and take a more neutral stance in the face of increased volatility. On the fixed income side, we expect a gradual flattening of the yield curve as short term rates will eventually rise faster than longer term rates. Where applicable, also look to increase exposure to overseas markets, both developed and emerging.
Potential risks to our outlook include uncertainty surrounding the Fed. For one, there is less direct support from the Fed now that quantitative easing has ended (though we feel the actual impact QE had on the economy had diminished significantly by the time the program ended). The economy could also be negatively impacted if the Fed moves too quickly or too aggressively to raise interest rates. Other risk factors include a rapidly rising dollar, a spike in oil prices, an unexpected turnaround in hiring and/or housing, a slowdown in Europe, and a weak recovery in China. As always, make sure to speak to your individual portfolio manager to assess your current investment allocation. Getting that one-on-one attention is part of what sets us apart. Take care and we look forward to speaking with you.