Fundamental investors cannot ignore macroeconomic conditions, although macro trends cannot always guarantee the generation of alpha. Knowing the macro context can help portfolio allocations and prepare investments for systemic risks, which is why the larger economic news is something that all portfolio managers spend some time examining.
These macro trends have been generally positive, but somewhat confusing. Today three very strong indicators of economic health converged to provide one of the clearest pictures we’ve seen in recent history of the unlikelihood of a negative downturn in economic growth, although whether this will correlate with positive equity returns is anyone’s guess.
Still, knowing what these trends are can help investors determine the chance of a downturn that they can then use to determine exactly how much (if any) of their assets should be in cash, short equities, or in bonds. Let’s take a look at each of them.
1. European Growth Strengthens
In 2014, the biggest risk to global growth by far was Europe. A mix of tensions over Ukraine, Putin’s apparent apathy towards economic growth at home, and a tug-of-war between the Bundesbank and the ECB all indicated that growth would slowdown markedly in China’s #1 export partner and America’s #1 ally. The European Union indicated weakness throughout 2014, and every data point from Eurostat showed more and more reasons to worry. The European SPDR (FEZ) has been stubbornly negative all year, with losses worsening in the second half of 2014, well after the worst of the Ukrainian crisis was over.
This greater weakness could be summed up in one word: deflation. European economic growth has been weak and inflation weaker throughout 2014, which led many to worry that the eurozone could see a deflationary spiral begin by the end of the year or early next year. Two economic releases today suggest that those fears were premature.
Firstly, Eurostat announced that the euro area has seen 0.2% GDP growth in Q3 and the EU saw 0.3% GDP growth. Weak numbers, but they are positive and an acceleration from the prior quarter’s figures. Some nations, like Greece and Portugal, showed very strong signs of growth, and most crucially France and Germany showed signs of health, as both turned to positive economic growth in the third quarter. Meanwhile, inflation in the eurozone accelerated from 0.3% to 0.4%.
2. Retail Sales see Strength
In the United States, signs that the consumer is getting more confident came in two forms on Friday. First, the Census Bureau announced that retail sales rose 0.3% month-over-month in October after a decline in sales in September. This growth in spending confirms what other recent indicators have suggested: the U.S. economy is recovering and American consumers are spending more.
Part of that spending strength may be a result of cheaper energy costs. Gas is getting very cheap. Heating oil is too, thanks to WTI oil futures that fell below 75%. While this has been horrible for oil stocks, consumer discretionary stocks (XLY) are up 4.5% YTD and have skyrocketed after the mini-correction of last month, when the sector was on sale. XLY is up 9.5% from its lowest point about a month ago.
3. Consumer Sentiment Rises
The third sign of strength comes from a softer but important indicator: the University of Michigan and Reuters consumer sentiment index for November rose to 89.4, up from 86.9 last month. It’s a small rise, but significant because it’s the highest level since 2007. The index has exploded in the last two years, up over 60% in that time. It’s also up about 60% from its lows during the crash of 2008 and 2009, and is above much of the late 2000s before the crash.
This soft indicator is still important because it is a barometer of aggregate demand. The U.S. is a consumer-driven economy, and many fears about the spending power of the average American have been a considerable headwind for U.S. stocks generally and XLF in particular. Some company management teams have warned on earnings calls that stagnant wages and low growth could hinder their revenue growth potential in the future.
The failure for revenues to grow has caused fans of the price-to-sales indicator to fret about an equity bubble. The P/S ratio for the S&P 500 (SPY) has stayed at near 1.8 for the second half of the year, a historically high point. Some have worried that revenue growth is needed to help stocks rise higher, and that can only happen if Americans buy more. If consumer sentiment is strong enough, that purchasing activity may begin in earnest.
With these three indicators showing health, equities traders are getting excited, especially as we are coming off the heels of a good earnings quarter. However, stocks traded sideways on Friday as many investors weighed the news and worried about valuations. More positive indicators are going to be necessary to cause the market to rise upwards, but for now hedging activity appears muted as comfort in the narrative of a global economic recovery strengthens.