From its intraday high on May 22 to its intraday low on June 24, the S&P 500 pulled back by 7.5 percent. This downdraft was catalyzed by a sharp selloff in the bond market that increased the yield on 10-year US Treasury notes to a high of 2.7 percent from a low of 1.6 percent in early May, heightening investors’ concerns about rising interest rates.
But the recent wave of selling in the market for US Treasuries appears overdone.
As I pointed out in the June 21, 2013, issue of The Big Picture, Don’t Fight the Fed – Listen to It, market participants have failed to appreciate that the Federal Reserve’s decision to phase out quantitative easing depends on the US economy continuing to strengthen. The Fed’s outlook for US gross domestic product (GDP) and the labor market appears overly optimistic, suggesting that the central bank is unlikely to scale back its monthly bond purchase before the Federal Open Market Committee’s December 2013 meeting.
And even if the US economy surprises to the upside and the Fed announces plans to scale back its quantitative easing at the September meeting, stronger growth should drive earnings expansion for cash-rich US companies. This tailwind will help to offset an uptick in borrowing costs.
At the same time, American consumers aren’t as vulnerable to rising interest rates as they were a few years ago. US households have gone a long way towards reducing their debt burdens in the wake of the 2007-09 financial crisis.
At its peak in 2009, US household debt stood at more than 90 percent of GDP–roughly double the levels that prevailed in the mid-1980s. But the financial meltdown prompted creditors to tighten lending standards and spurred consumers to save more and pay down their debts. Banks also wrote off loans to shaky borrowers. As a result, US household debt has declined to 80 percent of GDP, marking a return to levels last seen in early 2003.
Despite all the chatter about the potential for higher interest rates to derail the recovery in the US housing market, housing would still be affordable relative to historical norms if rates were to increase slightly.
Published quarterly by the National Association of Realtors (NAR), the US Housing Affordability Index has a value of 100 when an American family with the median household income has exactly enough to purchase a median-price existing home with conventional financing. The higher the index value, the easier it is for the average American family to afford a home.
The two times that the affordability index slipped to between 100 and 130 on my graph presaged significant pullbacks in the US housing market. Conversely, when the index hovered in a range of 130 to 145 for an extended period, the residential real-estate market was consistently healthy.
Rising interest rates on mortgages will make homes less affordable. But with the NAR’s US Housing Affordability Index coming off an all-time high, the property market is nowhere near the danger zone.
From a psychological perspective, the US housing market also has momentum. Two years ago, many consumers put off buying homes because the prevailing view (largely correct) called for home prices to fall further. However, with sales prices up more than 12 percent year over year, consumers feel pressure to buy sooner rather than later. In other words, rising rates and declining affordability create an even greater sense of urgency among prospective homebuyers.
Bottom line: Rising interest rates and the Fed’s Great Taper aren’t a huge headwind for the US economy or stock market.
More Confidence in Second-Half Acceleration
As I noted in Don’t Fight the Fed – Listen to It, the US economy has softened since late 2012, reflecting the initial shock of higher taxes and reduced government spending. However, the economy has adjusted to these new realities, setting the stage for growth to accelerate.
Two key economic releases support this outlook: the Bureau of Labor Statistics’ (BLS) Employment Situation report for June and the Institute for Supply Management’s (ISM) most recent Report on Business, which includes the widely watched purchasing managers’ indexes (PMI).
Even permanent bears would be hard-pressed to find negative news in the July 5 Employment Situation release. Private nonfarm payrolls grew by 202,000 jobs, trumping the Bloomberg consensus estimate of 175,000. In addition, the BLS increased its estimate of nonfarm payrolls for the preceding two months by a total of 70,000 new positions.
Average hourly earnings also ticked up 2.2 percent from June 2012. Although this improvement pales in comparison to pre-crisis levels, it’s still at the high end of the range for the past four years–a positive trend that suggests the labor market is finally showing signs of traction.
Meanwhile, weakness in the manufacturing PMI–one of my favorite indicators for the US economy–was one of the primary reasons that my outlook called for weak GDP growth in the first half of 2013. With the US economy expanding by 1.8 percent in the first quarter and second-quarter GDP growth likely to come in at less than 2 percent, this forecast appears to have rung true.
The manufacturing PMI slipped to 49 in May from 50.7 in April, indicating the manufacturing activity contracted slightly. But the June reading came in at 50.9, a level that suggests a rebound in the manufacturing sector.
Even better, the new orders component of the ISM’s manufacturing PMI–historically a leading indicator for the overall index–bounced back to 51.9 in June from 48.8 in May, suggesting that this improvement will continue in coming months and that the US economy is exiting the recent soft patch.
Although no economic indicator is infallible, the manufacturing PMI has a long history of predicting general trends in US GDP. Focusing on this indicator and ignoring the alarmist headlines that predominated in the financial media gave me the conviction to call for the US to avoid slipping into a recession in 2010 and 2011.
Although investors shouldn’t rule out the potential for the stock market to experience a modest pullback in coming months, the S&P 500 should claw its way higher through the balance of the year. Investors should regard these temporary downdrafts in the broader market as a buying opportunity.
How to Play It
As I explained in The Great Rotation, the sectors leading the market higher are poised for a shift: Consumer staples and other traditionally defensive fare trade near the upper edge of their historical valuation range. These stocks also offer inferior exposure to resurgent economic growth.
To profit from this trend, investors should deploy their dry powder in economically cyclical sectors such as energy, financials, industrials and information technology.
My article on the US manufacturing renaissance for the July 6 issue of Capitalist Times Premium delves into two of the most exciting growth trends in the industrial sector, a cyclical group that’s rife with as many traps as there are treasures. One of my top picks in this space stands to benefit from the upsurge in domestic oil and gas production and the push for US energy independence.
Source: Bloomberg, Capitalist Times Premium
How big is this opportunity? Consider that America’s net trade with OPEC members has contracted to a deficit of US$6.3 billion in May 2013 from an imbalance of more than US$18 billion five years earlier. With America unseating Russia as the world’s leading producer of natural gas and oil output rising at the fastest pace in almost half a century, this structural trend remains in its early innings.
Subscribe to Capitalist Times Premium today to learn about my top-rated industrial name, a stock that’s poised to benefit from a tidal wave of domestic and foreign investment in US petrochemical production.
Elliott H. Gue is founder and chief analyst of Capitalist Times Premium and Energy & Income Advisor.