May 2014 ended with the S&P 500 at an all-time closing high, while bonds also did well as interest rates actually fell from 2.65% at the end of April to 2.46% (basis US 10yr Treasury). (source: Yahoo finance)
So where do we go from here?
On the economic front, I expect the US economy to continue to growth at a steady, albeit lackluster, pace. This is probably a good thing, as slow growth is helping keep inflation low. Some of the positive factors supporting this conclusion are depicted in the image below. The 13 week average of initial unemployment claims has fallen to a 7-year low (source: DOL) showing an improving job market. However, the level of unemployment, which is declining but still too high, is keeping downward pressure on salaries, which is keeping wage inflation in check. The expanding use of shale oil & gas is reducing energy costs and the need to import these commodities. This combination of stable labor costs and lower energy costs is stimulating a resurgence of manufacturing and construction.
courtesy of ISI
The European economy has lagged the US because Europe chose to tackle the deficit problems of its weaker countries (such as Greece & Italy) via a strong austerity (cost cutting) program. This caused a double dip recession in Europe, which it is now showing signs of emerging from as the European Central Bank is adopting a more accommodative monetary policy to stimulate growth. The same can be said for the Far East, with the exception of China. However, while China’s economic growth has slowed, the new leadership in the Central Party appears to be committed to policies to support the economy.
On the investment front, my outlook is that the growth in the US equity market is reaching a mature stage but is not over. Corporate profit margins have been near record highs for the last couple of years so future earnings growth will be somewhat limited based on revenue growth. Earnings growth and the earnings multiple (price/earnings ratio) are essentially what drive stock prices. Since 2009 US stocks have been outperforming (on a relative basis) International stocks. Around a year ago International stocks broke a 5 year downtrend and now look poised to possibly outperform US stocks over the next 3-5 years. I base this outlook on foreign corporation profit margins being well below peak levels and International central banks being relatively more accommodative. (source: Riverfront Investment Group)
On the fixed income side, many financial texts will indicate that the bond market is a better barometer of the economy than the equity market. If that is true, then the recent decline in interest rates (basis US 10yr Treasury) would be indicating economic trouble ahead. However, I see the decline being more of a supply/demand imbalance rather than an indicator of economic outlook. The US federal annual budget deficit has declined from $1.5 Trillion/year in 2010 to around $500 Billion/year currently (source: Treasury Dept.). This decline has allowed the Treasury to issue less debt, thereby shrinking the supply of bonds in the market. Demand for Treasury bonds remains high from domestic investors as a safe haven investment, and foreign investors as bond rates internationally are lower than US rates. The US 10yr Treasury ended May 2014 @ 2.46%, while Japanese 10yr bonds were at 0.57%, German 10yr bonds @ 1.36% and European Central Bank 10yr bonds were at 1.56%. (source: Bloomberg). When supply is constrained and demand is high prices go up. When bond prices go up, interest rates go down.
In this environment I favor a diversified portfolio of equities and bonds will a slight increase in exposure to international stocks.
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