Resilience in the U.S. Economy, Further Contraction in the Eurozone

by Shawn Narancich, CFA Vice President of Research

Three for Three

 Encouraging economic data and an acceptable undertone to fourth quarter earnings underpinned the new year’s third consecutive week of stock gains, amid increasing evidence that retail investors are returning to the equity market. Mutual funds flow data showed investors once again adding cash to equity funds, a report that probably helps to explain another 1 percent gain in blue chip stocks despite ongoing concerns about U.S. fiscal policy and a flare-up of terrorist violence overseas. As investors speculate about the degree to which recent tax hikes will slow the economy, bond markets appeared to acknowledge the reality of a slow growth, low inflation environment by bidding Treasuries higher for the week.

Yen and the Yang

 Resilience is probably the best adjective we can use to describe a U.S. economy that continues to display evidence of forward momentum following Hurricane Sandy and the contentious fiscal cliff negotiations. From retail sales in December that outgrew expectations during a key seasonal period to the best housing starts number in four and a half years, the consumer continued to propel economic output at year-end. A key question is what consumption numbers will look like in the new year once workers experience firsthand the drag on their paychecks caused by expiration of the payroll tax cut. Despite the spending headwind created by higher taxes, the consumer discretionary stocks remains near the top of the sector performance charts year-to-date. The wealth effect of rising home prices, higher 401(k) balances, and lower gasoline prices are ameliorating factors that help explain why these stocks continue to do so well. 

While the U.S. economy continues to push ahead, Europe is at the other end of the spectrum, highlighted by further contraction in Eurozone industrial production and German GDP that finally fell into the red. Investors are well aware that the Eurozone is in recession, but the fact that it isn’t going out of business has so far been enough to support stock prices. What isn’t helping Europeexit recession is a resurgent euro, the common currency that has quietly risen from the low $1.20s last summer to $1.33 now. As developed economies struggle to support slow growth with expansionary monetary policy, major currencies are running a de facto race to the bottom that the euro is currently losing. Now, Japan’s new administration is staking its claim. With a yen that has quickly hit two and a half year lows against a dollar that has already lost ground to the euro, European exports suddenly look a lot more expensive to customers in two of the world’s three largest economies. Only time will tell how much deeper and longer a strong euro might make the Continent’s ongoing recession.

How’s Business?

As the interaction of currency markets impacts key economies, banks dealing primarily in U.S. dollars demonstrated the benefits of mortgage loan growth and better capital markets. Goldman Sachs, Morgan Stanley, and a host of regional banks delivered better than expected fourth quarter earnings and, despite the headwinds of rock-bottom interest rates that are pressuring margins, the outlook for this year remains reasonably constructive. In contrast, chip making giant Intel reported lowers earnings and warned that a declining PC market will continue to weigh on results in 2013. Investors turned tail and sent stock of the world’s largest semiconductor manufacturer down by a cool 6 percent.

With 15 percent of the S&P 500 having reported so far, about two-thirds of companies have exceeded earnings estimates. The pace of fourth quarter reporting picks up next week, with approximately one-fourth of the S&P 500 delivering results.

Our Takeaways from the Week

  • Stocks continue to make forward progress amid fiscal headwind
  • Earnings season is off to an encouraging start