Scott Minerd: Big Wheel Keep on Turning

Economic uncertainty from this winter soft patch will linger for months, but strong housing fundamentals should underpin a strengthening U.S. economy while low inflation augers well for stock prices.

by Scott Minerd, Chief Investment Officer, Guggenheim Partners LLC

February 26, 2014

This extended winter soft patch could lead investors and policymakers to question if something more fundamental than bad weather is to blame for weakness in recent U.S. economic data. Personally, I have a great deal of confidence that the U.S. economic expansion remains on track. Notwithstanding an unexpected surge in existing home sales for January, U.S. housing data has been mixed for months. However, the inventory of unsold homes is lower now than it was in 2004. Considering a likely rebound in household formation and strong fundamentals, once winter breaks, housing is primed for a surge in construction and sales that should boost GDP growth in the second half of the year.

It will most likely be late April before investors can conclude with certainty whether this weakness in economic data on everything from housing to retail sales is related to severe weather or if some larger force is at work in the U.S. economy. The betting has already begun in markets on whether the Federal Reserve will pause or slow the planned exit from its quantitative easing program, however, I do not believe policymakers will change from their pre-stated course.

At their March meeting, FOMC members are unlikely to find the data compelling enough to alter course and by the time they meet again at the end of April, the economy should be showing signs of improvement. Nevertheless, speculation is mounting, and bad weather and weak economic data are continuing. I see the possibility that yields on 10-year U.S. Treasuries will fall meaningfully from their current level of 2.67 percent. Of course, lower interest rates will provide a boost to underlying economic momentum and would support a recovery in second quarter housing activity, ensuring that the current soft patch is nothing more than a mirage.

After the S&P500 gained nearly 30 percent in 2013, and with stocks once again flirting with all-time highs, some have wondered if we are due for a correction which would crimp the wealth effect of rising markets. However, history suggests that in periods of low inflation, stock markets can sustain higher earnings valuations. Low inflation environments have historically corresponded with an average price-to-earnings ratio of 19.6 for the S&P500. The average P/E ratio for the index now sits at 17 and with the Fed not forecasting any imminent uptick in inflation, equities appear to have room to rise further. The recent surge in the NYSE Advance/Decline Line confirms this bullish sentiment.

We remain in a risk-on environment.

Chart of the Week

U.S. Stock Multiples Have Room to Expand

Low inflation tends to support larger price-to-earnings ratios, as the lack of price pressure facilitates easy monetary policy which encourages multiples expansion. Though the P/E ratio of the S&P500 has been on an upward trend in recent years, historical ranges suggest there is further room for expansion due to low inflation. With inflation expected to remain below the Fed’s target through 2015, the P/E ratio could rise as far as 24X and still remain within historical norms.
HISTORICAL P/E RATIO IN DIFFERENT INFLATION ENVIRONMENTS

Source: Bloomberg, Guggenheim Investments. Data as of 2/25/2014.

Economic Data Releases

U.S. Housing Activity Mostly Weak But New Home Sales Give Hope

• Existing home sales fell in January, reaching an annualized rate of 4.62 million homes, the lowest since July 2012. Sales have fallen five of the past six months.
• New home sales jumped in January to 468,000, an unexpected gain of 9.6 percent. The Northeast showed huge gains, calling into question the severity of the weather impact in that region. New home sales are a timelier gauge of housing activity, suggesting a housing turnaround may be in store in coming months.
• The S&P/Case-Shiller 20-City Home Price Index decelerated in December to 13.4 percent year-over-year, the first slowdown in growth since last June.
• The FHFA House Price Index surprised to the upside in December, increasing 0.8 percent from November, the best since May.
• The Conference Board’s consumer confidence index fell more than expected in February to 78.1, with a particularly sharp drop in expectations six months from now.
• Continuing a string of weak regional manufacturing reports, the Richmond Fed Index dropped to a seven-month low in February.

Quiet Data Week in Europe Shows German Outlook Continues to Improve

• The euro zone CPI rose 0.8 percent from a year earlier in January, the same reading as December.
• The German IFO Business Climate Index reached the highest level since July 2011 in the latest reading for February, continuing a four-month string of increases. The GfK consumer confidence index also showed continued strengthening in the outlook.
• Business confidence in France was flat for a second straight month in February, as the outlook for production dropped.
• U.K. retail sales dropped 1.5 percent in January, the largest decline in nearly two years. However, the drop followed a large gain in December, and yearly growth in sales remains near ten-year highs.

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