U.S. economic activity appears to have rebounded during the second quarter after a lackluster start to the year. We believe that improving labor market conditions are helping to revive consumer spirits. Despite risks from abroad and the specter of Fed rate hikes, our view remains that a rebound in corporate earnings growth over the second half of the year can help drive the market higher.
We are encouraged by the economic data released over the last several weeks. It appears that labor market conditions are healthy, with new and continuing jobless claims both hitting multi-year bests during the quarter and the latest job openings number reaching its highest level since the series began in 2000. Despite June’s meager wage growth of 2% as reported in the Bureau of Labor Statistics (BLS) Employment Situation Summary, most other indicators of compensation growth appear quite encouraging. The BLS’s own Employer Costs for Employee Compensation metric showed strong year over year growth of 4.9% for the first quarter, and a recent survey of CFO expectations for wage growth came in at just over 3%, the highest since 2007. Given the backdrop of a firming job market, it is not surprising that consumer sentiment has improved of late. Both the University of Michigan’s and the Conference Board’s monthly consumer surveys hit their second best levels of the current expansion in June. This renewed confidence also appears to be boosting consumption, as consumer spending grew by 0.9% in May, the largest month over month gain since August 2009. We have been calling for a back half acceleration of economic growth led in part by a healthier consumer, and this recent spate of data has increased our conviction in this forecast.
Turning to monetary policy, we had a fairly dovish take on the latest Federal Open Market Committee (FOMC) meeting held in June. Currently, seven committee members forecast no more than one rate hike during 2015. Following the March FOMC meeting, only three members held this forecast, with the rest expecting a greater number of rate increases. Moreover, during her press conference, Fed Chair Janet Yellen again emphasized her expectation that increases in targeted federal fund rates will occur in a gradual fashion. We continue to believe that a measured campaign of interest rate hikes need not derail stocks, and as we noted in last month’s letter, we were encouraged by the equity market’s resiliency despite the jump in bond yields during May.
On the international front, Greece once again garnered the lion’s share of investor attention during the quarter. As of this writing, conditions in the country remain highly uncertain with banks and the stock market closed, and no new bailout deal in place. With the ‘no vote’ having won the referendum, a Greek exit from the European Union now appears to be a possible outcome, whereas as recently as just a few weeks ago this scenario seemed highly unlikely. We have held the view that despite the amount of attention that this saga has received in the financial press, it is unlikely to have a significant, long term impact on the U.S. market. This is in part due to the greatly diminished exposure that international banks have to Greek debt, as well as the fact that the European Central Bank has launched its asset purchase program and established other programs to support troubled sovereigns and banks in the periphery if necessary to prevent a contagion. That being said, it is certainly possible that without a prompt resolution, international equities may see heightened volatility, at least over the near term.
With the S&P 500 currently trading at approximately 18 times forward earnings estimates, we do not expect much in the way of further multiple expansions. It will therefore necessitate a pick-up in corporate earnings during the back half of the year in order to drive stocks higher, in our view. Fortunately, we believe that conditions are supportive for this to occur. We see consumption as poised to drive economic growth moving forward, based on a healthy labor market and rising wages in particular. If the recent strength in consumer spending proves to be sustainable, it will likely drive a further acceleration in economic activity, which we believe in turn should help to boost corporate profits and ultimately stock prices.
Risk factors include the aforementioned Greek uncertainty. While we have taken some tactical steps to de-risk client portfolios in the event that the situation deteriorates even further, our expectation is that this will not significantly hinder the market over the longer term. Elsewhere, Chinese equities have shown extreme volatility of late. After rising about 60% over the past six months leading up to the decline, stocks traded in China and Hong Kong have corrected sharply. At this point we do not see evidence that this recent weakness is impacting capital markets globally. The run up in Chinese equities may have been decoupled from underlying fundamentals, as it occurred while the nation’s economic growth was decelerating. It is therefore conceivable that the weakness in equities of late is merely a correction of the excesses which had built up earlier in the year. We will of course continue to closely monitor the situation, and stand ready to act if we see any meaningful signs of contagion emerge. As always, we seek growth over the long term by protecting our clients’ capital in times of market distress.
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