The twin impacts of a rising dollar and falling oil prices over the past couple quarters have taken their toll on the markets and are a large reason why the S&P 500 has been more or less flat this year. Based on analyst estimates, Q1 is slated to be the first quarterly profits recession since 2009 in which earnings are expected to decline year-over-year by 4%. Is this cause for alarm? I do not believe so. Since 1960 we have seen quarterly negative earnings in non-recessionary years 31 times with the market up 60% of those times.
In addition to negative earnings estimates and the economy hitting a wall in the first quarter, others are citing the dismal March jobs report as evidence the US is slipping into a recession. While it is true employment trends slowed markedly in March, one weak data point does not make a trend particularly when viewed in light of other key indicators (see Five Reasons the US Is Not About to Enter Recession). Economic data can be quite noisy from month to month and understanding how business cycles end helps to filter this noise and remain calm.
Business recoveries typically end due to several types of excesses such as asset bubbles (think housing in the last cycle), excessive spending in cyclical sectors of the economy (think technology investment spending in the late 1990s), or high inflation (think of $145 oil back in 2008). As of today none of these excesses are present which leads me to believe that recession risk still remains far off on the horizon.
For starters, while the stock market has rallied considerably since the 2009 lows and is no longer cheap, in light of where interest rates are the price-to-earnings ratio on the S&P 500 is just slightly above its historical average. In terms of excessive spending in the cyclical areas of the economy, durable goods consumption and private investment spending as a share of gross domestic product (GDP) are below their post WWII average and well below levels associated with prior peaks. In fact, every single recession since WWII has seen the share of durable goods consumption and private investment peak north of 26% before the onset of a recession. Given that we are only at 24% currently and closer to recessionary lows than economic peaks, our firm believes there is still more life in the current expansion despite the many naysayers.
In regards to how inflation can quench an economic recovery, take a look at the annual inflation rate as measured by the consumer price index (CPI) below. Many contend that the Bureau of Labor Statistics (BLS) understates the true rate of inflation but let’s put that aside and not focus on the level of inflation, which can be easily debated, but rather focus on the overall trend. Shown below is the annual CPI rate in black while the red vertical lines are recessionary periods with data going back to WWII. As you can see, over the past half century recessions have always been either preceded by or associated with a spike in inflation—quite the opposite of what we see currently.
While it is highly unlikely that the US economic expansion will end any time soon, that is not to say that the ride going forward will be smooth. We at PFS Group believe Q2 will see the dollar continue to cool off after its big run, which will leave room for a recovery in the commodity space. Since reaching a high of just over 100 on the USD Index in March, the USD has softened a little which has led to a nearly 10% rally in oil this month.
The consumer discretionary sector was one of the top performing sectors in the first quarter but we feel it could come under pressure should energy prices rally.
Should the USD correct further for reasons outlined in late February (see here), large multi-national companies with sizable sales overseas should also gain traction as fears subside over currency translation issues with a strong dollar. This means that the muted returns in the large cap indices like the S&P 500 and Dow Jones Industrial Average seen year-to-date should give way to decent returns in the quarter.
The big wild card will continue to be the Federal Reserve this year as market participants try to decipher from the Fed’s statements clues as to when the Fed will raise interest rates, which should keep volatility elevated. For this reason and others, we do expect this year to be a bit bumpier than 2014.
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