A Tumultuous Year Ahead

Wall Street’s S&P 500 Year-end Forecasts:

  • Federated Investors: 2350
  • RBC: 2325
  • Morgan Stanley: 2275
  • J.P Morgan: 2250
  • BTIG: 2200
  • Blackrock: 2160
  • Barclays: 2100
  • Goldman Sachs: 2100

Wall street firms polled by Birinyi Associates see the S&P 500 rising an average 8.2% this year as accelerating economic expansion and corporate earnings growth outweigh the detrimental effects from increasing rates. This comes after the S&P 500’s 11.4% gain and 53 record highs last year, extending the US bull market toward its 6th year anniversary this March.

Not one firm polled sees equities declining despite the Fed’s warnings of increasing volatility as they normalize rates. The Fed’s proclamation has already come true with VIX averaging 19.3 so far this year compared to last year’s average of 14.3. Despite higher volatility, stocks so far remain flat.

Studies show that stocks can continue to climb during the early stages of a tightening cycle (WSJ). Ben Carlson provides more detail in his Wealth & Common Sense blog, revealing that out of the 14 tightening cycles since 1950, in only 2 instances stocks lost value (bonds lost value half of these times). Furthermore in no instance was the rest of the globe embarking on massive QE while the US was normalizing rates, a situation that will offset any Fed effect (other than a strong dollar).

The dollar will continue to rally, fueled by the widening monetary divergence between the US and the rest of the world. Nevertheless any currency pressure on exports (13% of GDP) will be offset by low interest rates and oil prices. Depressed by an influx of foreign capital from the ECB ($68 billion/ month QE starting March) and BOJ ($60 billion/ month QE), lower interest rates will help US consumers (71% of GDP) in the form of lower borrowing rates, and corporation in the form of higher margins.

While the Fed has fixated on a June rate increase, international demand for higher yielding US assets will dampen the effect of the Fed’s rate hikes, holding interest rates low while boosting stock higher. TIC flow data (November: +$53.5 billion) already showed a record $6.112 trillion in Treasury bond held by foreign investors. Their insatiable demand will nearly create a bubble in US assets as long as their central banks keep printing money.

Equities are already pricey with the S&P 500 trading at 16.3 times forecasted earnings at the end of 2014 versus a historical average of 13.9 (WSJ & Factset). Similarly the index trades at 1.7x its expected sales this year, 31% higher than its 10-year average of 1.3. Nevertheless stocks will find momentum in earnings growth, forecasted at +6.3% for the full year which would be the best yearly performance since 2011 (WSJ).

Already pricey US assets temper Goldman Sachs PWM’s forecast to a 4.7% to 8.4% gain for the S&P 500 this year. Instead they recommend 2 foreign markets: Japan and Spain. Similarly Blackrock suggests cheaper Asian stocks like China and Japan (beware China’s margin levels).

Unfortunately strong economics correlates into stock performance worse than rainfall (Vanguard). While the US is a positive outlier economically, Barons reminds us of “the much heralded initial jobless claims numbers that hit a 14-year low last fall. That number also hit lows in June 1987, March 2000, and June 2007, which were all close to major market highs.” Beware for a precipitous decline in US stocks once the rest of the world stops printing money.

Treasury Volatility

The influence of high-frequency traders in the Treasury market is growing. About 60 percent of Treasury securities trades are expected to be transacted on electronic platforms by the end of next year, an increase from 40 percent in 2013, according to Tabb Group LLC, a New York-based research firm. Of those trades, 10 percent were executed by robots in 2010, a share that will probably grow to 20 percent next year, according to Tabb (Bloomberg).  So much depends on Treasury Yields; fluctuations from robotic trading like that on October 15 could ripple across the broader economy.

Adjusting Interest Rates Lower

Major banks have adjusted their interest rate forecasts given a weaker outlook for the global economy. 10-year Treasury yield year-end expectation over the course of this year:

                                 Start of 2014              Mid-Year              Current

Goldman Sachs:           3.25%                       3%                    2.5%

JP Morgan:                    3.65%                     2.7%                  2.45%

BofA:                                 3.1%                     3.1%                  2.75%

HSBC:                               2.1%                     2.1%                   2.1%



WSJ Monthly Survey of Economists

Faster job growth, consumer confidence (albeit volatile recently) and lower energy prices will boost US growth in the 3Q (+3.2%) and 4Q (+3%) this year.  Inflation adjusted consumer spending will grow 2.6% in the 2H this year, helped by lower energy prices (by 13bp in the 3Q and 21bp in the 4Q).

Oil prices are expected to close 2014 at $91.16, down $9 from June predictions. Inflation expectations are consequently lower, expecting annual CPI growth of 1.9% by year end.
Employment growth will average 214,000 over the next year, (227,000 current year average). Therefore unemployment will finishing the year at 5.8%, then finish 2015 at 5.4%.

The only headwind to growth lies internationally as Europe and Asia slow, while a stronger dollar curb US exports. That and some hesitation to higher interest rates… but higher rates only come when the economy is strong enough to support them.

THE TRADE (risk off) buy dollar, treasuries and sell Euro, Yen, commodities, small-caps and emerging markets.  Buy domestic large caps with little international exposure.  Dollar vs. Ruble looks perfect.

This just about sums it up.

An illuminating income and spending report last week:

August Personal Income & Spending: +0.3% & +0.5%. Both gauges rise as expected, given the strong August retail sales report (8/16/14 showing a +0.6% gain). Compared to last year, income (+4.1%) is outpacing spending (+4.4%), resulting in a little savings. Consumer prices were unchanged in August, leaving a very calm (+1.5%) annual gain that gives the Fed room to keep rates low. Core consumer prices gained (+0.1%) in August but also remained at a subdued (+1.5%) rate. Expansionary monetary policies in Europe and Japan will keep interest rates low, strengthen the dollar and keep inflation at bay.

A Widening Rift

Both Bond and Equity markets roared to life in August.  The Dow posted its biggest gain since February (+3.2%) while the 10-year Treasury had its best month since January, pushing its yield to a 14-month low Thursday.   Equity investors root for a recovering US as the S&P 500 hits an all time high even as bond investors retrench from a deflationary Europe and crisis in Ukraine.  Bonds and stocks cannot both rally indefinitely; one must fall.  The smart money always flows to fixed income, just like in 2007.