Market strategy viewpoint – June 25, 2009
Marc A. Zabicki, CFA – Sr. Market Strategist
Market Should Mirror Slow Recovery
- Economic Indications Still Soft. The equity market has priced in a more rational environment, yet the reality of a slow recovery from the cyclical, economic trough has begun to set in. Economic indications have improved, but still show little sign that more robust growth is on the horizon. Consequently, the most likely case of slow economic growth as we exit the current recession should keep equity returns modest.
- Market Weakness Provides Window To Increase Cyclical Exposure. The latest equity weakness is offering an opportunity to raise cyclical equity exposure at more attractive prices. With this in mind we are increasing our sector allocation on Industrials from Equalweight to Overweight, while lowering our Consumer Staples exposure to Equalweight from Overweight, and our Consumer Discretionary exposure to Underweight from Equalweight. Meanwhile, we are upgrading the Energy group to Equalweight from Underweight and downgrading Utilities to Underweight from Equalweight.
- Income Increased In Importance. With a likely sluggish equity market for the foreseeable future, investors need to be cognizant of the income portion of the total return equation. In our view, investment grade corporate bonds and high-grade municipals offer relative value and are a good income source.
- Bernanke Preparation. While his term does not expire until January 31, 2010, investors should brace for some uncertainty surrounding Ben Bernanke’s reappointment as Federal Reserve Chairman. Odds favor a Bernanke reappointment, but the discussion of his record will indeed take place in media headlines over the coming months.
PLEASE NOTE: FOR IMPORTANT DISCLOSURES, INCLUDING POTENTIAL CONFLICTS OF INTEREST, PLEASE SEE THE LAST PAGE OF THIS PUBLICATION.
Current Correction Should Prove Modest
After staging an extraordinary rally the U.S. equity market has given some of those gains back. To us, this correction is somewhat overdue and we expect it to be modest in nature. The S&P 500 Index bumped up against some intraday resistance around the 950 level and has bounced off support in the 890 area. Failure to sustain these levels and/or the 50-day moving average (897) could see equities fall further to the psychological 850 number. We believe market sentiment and renewed realization of fundamentals will keep the current bout of equity weakness relatively contained. Indeed, the market has seemingly found its legs as this piece goes to publication, with the market showing willingness to hold all the near-term support levels mentioned (circle). Should the market turn lower and endure a more protracted correction, revisiting the March lows is not in the cards, in our view, due to the greater rationality in the current market. We believe the February and early March trading represented extraordinarily irrational expectations that have since been corrected by a sensible assessment of the business cycle.
Source: Stockcharts.com; Ameriprise Advisor Services, Inc.
Using Market Weakness to Grow Cyclical Exposure
The latest equity weakness is offering an opportunity to raise cyclical equity exposure at more attractive prices. With this in mind we are increasing our sector allocation on Industrials from Equalweight to Overweight, while lowering our Consumer Staples exposure to Equalweight from Overweight, and our Consumer Discretionary exposure to Underweight from Equalweight. Meanwhile, we are upgrading the Energy group to Equalweight from Underweight and downgrading Utilities to Underweight from Equalweight. In our view, these shifts bring our U.S. equity allocations more balanced with no bias toward cyclical or defensive exposure.
We like the Industrial sector, at this time, because of the internationally diversified nature of the businesses and the focus on infrastructure spending both domestically and globally. The group participated fully in the market rally, but has recognized significant weakness of late, offering, in our view, an attractive entry point. We are reducing our defensive bias by downgrading the Consumer Staples group. The sector could come under some product pricing pressure in our view, and some tough near-term earnings comparisons. Meanwhile, our downgrade of the Consumer Discretionary sector is a function of balancing cyclical and defensive exposure and a lack of confidence in consumer spending habits. We believe we are witnessing a structural shift in consumer habits (higher savings rate) that could put continual pressure on discretionary spending. Our upgrade of the Energy group indicates our belief that economic growth both here and abroad should keep a positive bias on oil and natural gas prices. These commodity prices may prove volatile in the near term, but we see higher prices by the end of the year. And finally, our outlook for higher Treasury yields is the primary catalyst for a downgrade of the Utility sector. Historically, Utility stocks have had an inverse relationship with Treasury yields and that relationship should be reflected in weaker utility stock prices as we move forward.
Note: S&P 500 market capitalization as of 6/19/09, numbers may not
add due to rounding
Source: Ameriprise Advisor Services, Inc. (AASI); S&P
Source: Ameriprise Advisor Services, Inc.
Market Should Mirror Slow Recovery
Now that the market has rallied from what were irrational expectations earlier in the year, the market’s pace will likely be set by ongoing economic indications. In aggregate, economic numbers have been better than those seen in late Q4/early Q1, but the data has been far from spectacular. And we expect this to continue. Indications will improve as we move through the year. However, we are only expecting modest improvement on the scale not typically seen in past periods of economic recovery. Historically, economic recoveries have ushered in GDP growth rates of 3% or 4% during the early stages of a rebound. Current forecasts are calling for GDP growth to close this year at a 2% annual pace and only an approximate 2.5% growth pace is expected for the 2010 calendar year. With the current rebound expected to be shallow, we anticipate equity returns will reflect this phenomenon. In our view, we have already seen the market put in its most robust gains for the year, and the remaining months’ performance should be more in line with economic direction.
We have commented of late on the structural shifts taking place within global economies wherein deleveraged corporate and consumer balance sheets will have a detrimental effect on overall spending. Net worth at the corporate and consumer level has been damaged and lower spending will likely be the result as individuals and companies repair their balance sheets. Lower spending should in turn establish higher levels of sustained unemployment and help facilitate greater consumer savings rates. These moving parts should indeed reduce expectations for equity returns for the balance of 2009 and likely 2010 as corporate revenue and profit recovery are held down.
Global Economic Indications Provide U.S. Equity Insight
We typically use global data in assessing real demand in the economy and thus the potential impact of demand on U.S. equity prices. Global trade activity from the export-heavy economies of Japan, China, and Germany has been particular telling of late when seeking to decipher underlying economic demand. Most notably, recent export data from these countries tells us that demand indeed remains sluggish. These countries export heavily into the U.S. and the European economies, regions that are responsible for a large portion of global demand. Still however, the latest data from Japan, China, and Germany (see graphs below) indicate few positives in our demand assessment. Export activity has remained rather sluggish and in some cases has deteriorated versus previous months. The data tells us that export demand from global economies, particularly the U.S. and the Eurozone economies, is less than that typically seen at this stage of an economic recovery. We believe the results to date help confirm the likely deleveraging impact on demand and signal that equity price expectations should remain subdued at this time. We would look for export data out of these countries and others to sustainably improve before we can formulate a more positive assessment of underlying economic demand and equity return potential.
German exports again moved lower after staging a modest recovery in February and March.
Source: Economy.com; AASI
China's global export reach and to-date weak data may be the most telling export indicator of real demand.
Source: Economy.com; AASI
Japanese data improved from a steep trough but sill indicating sluggish demand for goods.
Source: Economy.com; AASI
Treasury Yields Should Trend Higher
The direction of interest rates has been a hot topic among investors over the past several weeks. Inflation concerns have made headlines, the U.S. fiscal budget and new Treasury issuance has also been a key worry. The developments have been paramount in increasing the upward trajectory of Treasury yields in recent weeks (see graph below). While the inflation worry is overblown in our estimation (high unemployment, low capacity utilization, a wide economic output gap, and global competition do not lend themselves to realistic inflation scares at this time), fiscal deficits and spending plans by Congress and the White House should indeed keep upward pressure on Treasury yields. The Congressional Budget Office has estimated a $1.67 trillion budget deficit for 2009 and $1.83 trillion when accounting for the Administration’s budget proposal. In 2010, the CBO estimates that the budget proposal will add about $300 billion to an estimated budget shortfall of $1.14 trillion. To account for the expected deficits, the Treasury is in the process of auctioning historic levels of debt this week (the week of June 21) and more such auctions are expected in coming quarters. The additional supply should be significant for the market to digest, which could cause yields to rise steadily. And while we have downplayed the strength of the economy, it is likely moving in a positive direction. This directional economic improvement will also pressure Treasury prices (higher yields) and eventually cause the U.S. Fed to tighten policy.
Source: Stockcharts.com; Ameriprise Advisor Services, Inc.
Income Importance High In This Market
We have been consistent in imploring investors to consider the U.S. investment grade corporate bond market and the high-grade municipal bond market as attractive alternatives in a volatile equity market. With Treasury yields trending higher and equity capital gains likely held back by ongoing economic and financial clean-up, investors, in our view, would be right to turn to corporate and municipal bonds as attractive total return opportunities. Favorable yields and capital gain potential may provide investors with competitive total return options versus other asset classes. Investors taking long bond positions now should receive attractive income and likely realize favorable price returns as the economy continues to dust itself off. To help shield from the impact of a potentially rising rate environment, we suggest investors keep their investment grade corporate and high-grade municipal exposure relatively short in duration. Also of importance is security selection. In an environment with still considerable risks to the downside, investors will be better served by remaining conservative and choosing the most steadfast corporate and municipal names. With the current wide spreads across the board in these groups, we see no reason to extend risk by chasing yield or oversubscribing to the high-yield arena.
% numbers may not add to 100% due to rounding
Source: Ameriprise Advisor Services, Inc.
% numbers may not add to 100% due to rounding
Source: Ameriprise Advisor Services, Inc.
The Bernanke "Debate"
The financial markets may be subject to a little more uncertainty than usual over the next few months due to likely talk about the potential reappointment of Federal Reserve Chairman Ben Bernanke. Bernanke’s term expires on January 31, 2010, and while President Obama has made some favorable comments regarding the Fed Chief, he has yet to signal his interest in reappointing him. Headlines over Bernanke’s role in the Bank of America’s (NYSE: BAC; $12.20) takeover of Merrill Lynch, and questions over extending the Fed’s role as the top financial regulator should keep uncertainty high over Bernanke’s defensible position as the ongoing chief central banker. Names such as Lawrence Summers and Janet Yellen, both former Clinton staffers, have entered the mix as potential successors, failing a reappointment.
The political process and the surrounding speculation over Bernanke’s reappointment are unfortunate and may serve to unsettle markets only at the margin. In the end, odds are that Bernanke will be reappointed, and we believe rightly so. We applaud his handling of the financial crisis as he rewrote the monetary policy playbook to keep the system pumping. In our view, his record in crisis and overall stands steadfast and worthy of another term.
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DIRECTOR OF RESEARCH |
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SECTOR ANALYSTS |
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Consumer Goods and Services |
Health Care |
Energy / Utilities |
Industrials / Materials |
Financial Services |
Technology / Telecommunications |
PORTFOLIO STRATEGY ANALYSTS |
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| Economic Strategist Russell T. Price, CFA |
Model Portfolio Strategists Matthew J. Koellner, CFA Steven F. Shepich, CFA, CPA |
Market Strategist |
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PACKAGED PRODUCT ANALYST |
ALTERNATIVE INVESTMENTS Timothy M. Witt |
| FIXED INCOME LIAISON Marc A. Zabicki, CFA |
ADMINISTRATIVE ASSISTANT |
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