The US economy continues in a rather comfortable groove of low inflation, low interest rates, and low economic growth...low at least relative to how we remember past business cycles (Chart 1). Credit and liquidity are plentiful; the economic expansion is making up in length for what it has lacked in strength.
Chart 1 | Quarterly Growth in US Gross Domestic Product
Inflation is still well below the Federal Open Market Committee's (FOMC) long-run 2% objective, so the FOMC can normalize interest rates in a gradual and well-telegraphed fashion that does not alarm markets. In the post-war period, the stock market peaks on average 30 months after the first official rate hike.
The FOMC is also reinvesting principal payments from its debt holdings and rolling over maturing securities, preserving highly accommodative monetary conditions. Real (after inflation) interest rates are likely to remain low for a considerable period.
With approximately 60% of S&P 500 companies having reported second quarter earnings, 70% of them have beaten expectations. The quality of these earnings, however, remains poor with companies missing on the top-line, but driving bottom-line growth through margin expansion and robust share buybacks.
The dividend yield on the S&P 500 Index averages 2% and is rising (Chart 2). Corporate cash balances are substantial. Merger and acquisition activity is booming.
Chart 2 | S&P 500 Dividend Yield
Rising from the near collapse of our financial system and a severe recession, this bull market has lasted longer and advanced further than the average post-war experience. Not surprisingly, absolute measures of valuation suggest stocks are expensive (e.g., market capitalization/GDP, equity market value/equity book value, and the cyclically adjusted price/earnings multiple).
Yet, the age of the market cycle, the degree of the advance, and measures of valuation are poor tools for market timing. They will become more relevant -- in retrospect -- once the cycle turns.
Wild cards in the outlook come mainly from outside the US. Some are in the headlines and others are harder to glimpse, such as those connected to the super-charged carry trade environment.
First and foremost is China in light of what is perceived as a stock market crash, collapsing commodity prices and credits, weakening business activity, and a real estate property downturn. This is of consequence because China is the world's second largest economy and leading generator of growth in 2014.
China has three classes of stock. Foreigners are largely limited to the H shares listed on the Hong Kong Exchange and its benchmark is the Hang Seng China Index. The other two are Shanghai A shares and Shenzhen, which are mostly high tech and small cap.
Shanghai is largely a casino and Shenzhen is the Wild West! Shanghai trades at a 14 price/earnings multiple, Shenzhen at 17 times, but Hong Kong H shares at only 9 times. The wheat needs to be separated from the chaff.
The Shanghai A Share Index is actually up 15% year-to-date, but this is on a "soft close" with:
- almost 20% of stocks trading down the limit on Friday, with trading suspended,
- banks encouraged to increase lending to investors,
- interest rates cut,
- large shareholders (over 5%) still blocked from selling (which has turned off Western institutions),
- state-owned companies and funds told to buy stocks,
- initial public offerings frozen,
- bid/ask spreads at historically wide levels,
- stock borrowing impossible,
- short-sellers threatened, and
- people spreading "rumors" arrested.
It is hard to see China through American eyes.
Meanwhile, emerging market currencies have fallen to 15-year lows. Brazil's outlook was cut to negative by S&P.
Today, trading resumes on Greece's stock exchange, with the short selling ban continuing. Last week, bail-out negotiations started between Greece and its official creditors...with deep differences remaining.
The International Monetary Fund and many economists believe that any Greek rescue will not be viable without restructuring Athens' high debt level. Yet, classic haircuts in government debt are incompatible with a country's membership in the Eurozone.
Iran and the P5+1 have come to an agreement on temporary limits on certain nuclear activities in exchange for phased sanctions relief, adding to downward pressure on crude oil prices. Israel remains on high alert regarding its security.
In our imperfect and dangerous world, the US remains healthy and, on a relative basis, a safe haven for investors. As befits a strong country, our currency is likewise strong.
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