Equities Relatively Flat as Crosscurrents Remain

U.S. equities finished mostly higher last week, and the S&P 500 advanced 0.50%.1 The Dow Jones Industrial Average was the only the only major U.S. index to falter last week.1 Market sentiment was dominated by the notion that the market had become too bearish in the wake of the prior week’s sell-off in equities and credit. Continued improvement in global recovery sentiment seemed to provide a notable tailwind. The Fed dominated headlines — markets appear obsessed with policy normalization and succession issues.

Looking Beyond the Fed to Earnings Growth

It seems further deterioration in earnings sentiment failed to do much damage to U.S. equities. Barron’s recent cover story about earnings noted that cost cutting measures to improve margins have largely been exhausted and indicated third quarter earnings per share growth expectations have been reduced considerably. The article added that fairly resilient expectations for 10% growth in fourth quarter appear optimistic considering revenues are only anticipated to increase 0.5%.2

Currently investors appear to be struggling with the distinction between Fed tapering (slowing the rate or amount of quantitative easing) and tightening (raising the fed funds rate). We believe tightening is unlikely before the end of 2014. Can equities extend their rally in the near term against a backdrop of rising rates? The data seems to support that this is possible, but it likely depends on how much rates rise and whether or not inflation becomes an issue. Low nominal economic growth environments such as this one make it difficult to make money. Periods of low nominal growth should intensify the focus on revenue and free cash flow growth.

Weekly Top Themes

1. Initial jobless claims increased 13,000 to 336,000.3 We note that the 4-week moving average decreased to 331,000 during the week of August 17. In our opinion, this was the best result during the expansionary period.

2. The manufacturing Purchasing Managers’ Index (PMI™) edged up in the preliminary August report.4 This was the highest level for the PMI since March, and the survey shows some improvement between the second and third quarters.

3. Core inflation (CPI) rose 0.2% in July and has increased 1.7% year-over-year, in line with expectations.5 We are not convinced the recent move up is a start of a bigger trend. We maintain our view that inflation will not be a factor in the short term, but eventually there will be a moderate increase.

4. The fiscal fatigue that followed the fiscal cliff may be set to reappear. Macro tail risks will likely return in the fourth quarter: the risk of government shut down, Obamacare, sequester, debt ceiling debate and the nomination battle for the Fed Chairman. Federal fiscal tightening is more than $300 billion in 2013, or nearly 2% of GDP.6 Next year, we anticipate it will be negligible. At the state and local level, improving finances have largely delayed further fiscal tightening. A shift toward neutral fiscal policy should provide favorable conditions for GDP in coming quarters.

5. A European recovery seems to be getting underway. From the data, we find it hard to tell whether improvement will continue. Among our concerns: consumers are under pressure, unemployment rates remain elevated, wage growth is low, debt loads are high and the credit cycle is repressed.

The Big Picture

We remain constructive on the outlook for the global economy and risk assets in the year ahead. Our base case economic scenario calls for a moderate pick up in global growth led by the U.S., and Japan to a lesser extent, while Europe bottoms and China continues to muddle along. Improved global growth bodes well for the performance of economic-sensitive sectors. Reflationary policies from G7 central banks continue to gain traction and should provide a tailwind for equities, assuming earnings advance. Having said this, we have been expecting the second half of the year to be a bumpier ride. Markets would be less susceptible to Fed tapering conversations if corporate earnings were healthier and expectations for growth were higher.

1 Source: Morningstar Direct, as of 8/23/13. 2 Source: Barron’s, Hough, Jack, “Beware Falling Profit Estimates,” August, 19, 2013. 3 Source: U.S. Department of Labor, “Unemployment Insurance Weekly Claims Report,” August 22, 2013, http://www.dol.gov/opa/media/press/eta/ui/current.htm 4 Source: Institute for Supply Management, “July 2013 Manufacturing ISM Report on Business,®” August 1, 2013, http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942. 5 Source: Bureau of Labor Statistics, “Consumer Price Index Summary – July 2013,” August 16, 2013, http:// www.bls.gov/news.release/cpi.nr0.htm. Core inflation (CPI) represented by All Items Less Food and Energy. 6 Source: Congressional Budget Office, “Monthly Budget Review for July 2013,” August 6, 2013, http://www.cbo.gov/publication/44495.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Euro STOXX 50 Index is Europe’s leading Blue-chip index for the Eurozone and covers 50 stocks from 12 Eurozone countries. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. FTSE MIB Index is an index of the 40 most liquid and capitalized stocks listed on the Borsa Italiana. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The MSCI World Index ex-U.S. is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets minus the United States. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.


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