New Year, New Worries

by Shawn Narancich, CFAExecutive Vice President of Research

Deja Vu

Much like January of last year, U.S. stocks are off to a rocky start in the New Year, thanks to a European economy on the verge of stall speed and a plummeting price of oil that’s making investors feel like something other than a small surplus of excess production is afoot. Even after the recent volatility, blue chip stock prices have still tripled since their lows exiting the financial crisis in 2009 and have outperformed international stocks by a whopping 70 percent over the past five years. The question on everyone’s mind is whether a U.S. economy, having now wrapped up what we expect to have been its third consecutive quarter of 3 percent or better growth, can continue to decouple from troubled economies abroad. We still believe that will be the case, as Americans benefit from lower energy prices and a much healthier job market, but positive equity returns in 2015 aren’t likely to come as easily as they did last year.

Banking on Profits?

Our expectation is for U.S. profits to grow by mid-to-high single digit rates in 2015 but, at least for the final quarter of last year, Wall Street expectations are much more subdued. As the fourth quarter earnings season kicks off, investors are expecting earnings to have grown at just a 1 percent clip, reflecting plunging oil prices that will assuredly dent the profits of big oil companies like Chevron and Exxon. What Wall Street may be missing is the positive impact of low oil and natural gas prices on 90 percent of the market’s constituents that are net users of oil and natural gas. While earnings for multi-national companies are likely to be dampened by the stronger U.S. dollar, a clear plurality of publicly traded companies will benefit from lower energy costs that should help boost profit margins.

Regardless of your persuasion, few will argue about the decidedly poor results that banks delivered this week as JP Morgan, Bank of America, Wells Fargo, and Citigroup reported earnings that collectively fell by 12 percent in the period. Unfortunately for investors, the numbers came up short of expectations in all but one case (Wells Fargo), prompting sell-offs in all four names. While lending volumes have picked up in recent quarters, net interest margins are under pressure as deposit costs remain near zero and new loans are underwritten at increasingly low rates. JP Morgan demonstrated that legal costs related to the housing crash remain a meaningful expense item years after the fact, while each of the investment banks reported disappointing results from fixed income, commodities, and currency trading. As reporting season transitions to a broader swath of companies next week, we expect to see more encouraging results.

Off Target

In a move only mildly surprising to those who have followed its travails in Canada, Target announced this week that it will be exiting the country just two years after its first store opening up north. Having never made a penny there, the general merchandiser’s new CEO Brian Cornell has pulled the plug, acknowledging that management couldn’t foresee profits before 2020. The result of Target’s Canadian misadventures? Nearly $6 billion of accumulated losses and write-downs, equivalent to more than the company’s entire profitability for the past two years combined. Yes, this is what gets CEO’s fired, and is a key reason why prior leader Gregg Steinhafel showed himself to the door early last year.

Our Takeaways from the Week

• Lower stock prices in the New Year reflect worries about flagging growth internationally and dislocations in key foreign currencies

• Fourth quarter earnings season is off to an inauspicious start thanks to disappointing results at four major banks

Disclosures

Reeling in the New Year

by Jason Norris, CFA Senior Vice President of Research

With 2013 coming to a close, one of the most frequent questions we have received is, “What’s the encore?”  The S&P 500 rose over 32 percent, the best return since 1997. Will 2014 result in profit taking or will there be continued follow through as investors deploy their cash?

A year ago, investors were looking at a lot of uncertainty with the pending government sequestration, increasing taxes (as you recall, the payroll tax was increased to 6.2 percent), as well as international questions with Europe and a possible slowdown in China. Those fears, at least by market perception, were put to bed as the Federal Reserve continued to hold interest rates down with their bond buying program. As the U.S. economy showed steady gains and the Fed signaled the end to quantitative easing, investors chased stocks higher and exited bond positions. In the last six months of 2013, over $175 billion left bond mutual funds but only $75 billion found its way into equity funds. We believe there is still a lot of cash to be deployed in 2014.

Against the Wind

2014 will be the advent of the Janet Yellen tenure at the Fed, a mid-term election, as well as the conclusion of QE3. We continue see slow improvement in economic data for the U.S. economy. Unemployment claims are trending lower (after a volatile month due to the holidays). Manufacturing data remains healthy, as reflected by this week’s PMI reading of 57 (a score of 50 or above signals strength). The U.S. consumer remained engaged into the end of the year as retail sales rose over four percent (primarily driven by double digit on line sales growth). Finally, the housing market is improving with prices rising and inventories falling.

What could derail the expansion? Rising rates. As the Fed unwinds its bond buying, we believe rates will continue to trend higher. Will these higher rates be a meaningful headwind to growth and equity returns? We don’t believe so. However, we will be monitoring closely.

Back for More

This brings us back to the first question: what does 2014 have in store after such a strong 2013? Looking at historic returns, equities revert to their averages. Since 1928, there have been 17 periods when stocks returned over 30 percent. The following year, equities averaged an 11 percent return and were positive two-thirds of the time (in line with historic annual returns). Therefore, this year, equity returns are going to be contingent on corporate profit growth and market valuation, which we believe are both constructive.

We hope you all have a healthy and prosperous 2014 and we look forward to seeing our clients and friends at one of our many Investment Outlook presentations over the next six weeks.

Our Takeaways for the Week:

• The retail investor remains skeptical of equities
• The U.S. economy continues to show steady improvement

 Disclosures