Concerns about the US economy coupled with a strong dollar
Posted on 2 February 2015
"The persistently higher dollar is negating the former market consensus of 8% earnings growth for the S&P 500 Index"
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A spate of recent weak economic and earnings releases has investors questioning the strength of the US economy. Until now, sentiment toward growth prospects has been remarkably immune to the growth concerns investors have held about most of the global economy. The concerns are increasingly manifest in share prices, as US equity indices are posting losses, while European and Asian equities are enjoying gains so far this year. While the 2.7% decline that the S&P 500 Index has reported this year casts a pall over the expectant New Year hopes of investors, the index is still roughly 1.7% above its December 16 level when the market began an impressive holiday rally. Whether the recent weakness is a manifestation of growth concerns or is a technical pullback remains to be seen. We suspect that it is a bit of both.
On the matter of growth concerns, this week’s durable goods report was a surprise. The headline report of a 3.4% decline in orders in December marks the fourth drop during the last five months. Combine shrinking capital expenditure (mostly due to energy) with punky earnings due a strong dollar and weak end-market demand from companies such as Proctor and Gamble, Pfizer, and Caterpillar, and the conditions are complete for a buckling of investor resolve.
Juxtaposed to the durable goods report and the string of weaker-than-expected earnings was a remarkably robust reading of consumer confidence from the Conference Board. The January reading jumped from 93.1 in December to 102.9. This was the highest reading since August 2007 when it stood at 105.6. Current and future confidence also rose, and the number of people who expect their incomes to grow registered a nice lift, rising from 16.2% in December to 20% in January. Since the US economy is primarily driven by consumption (70%) rather than investment (15%), the weight of data continues to argue for an economy that will grow something on the order of 3%.
On the matter of earnings, growth expectations for the current earnings season have shrunk considerably over the course of the last couple of months. The tendency for Wall Street to revise earnings estimates lower over the course of the quarter is well-known; however, the magnitude of the current expectations reset is considerable. The current picture of fourth-quarter earnings is multifaceted. With approximately 30% of companies in the S&P 500 index reporting earnings, profits on a share-weighted basis are up 4.0%. If we back out financial companies from the calculations, profits have logged a gain of just under 10%.
As might be expected, earnings estimates for 2015 are getting revised lower. We expected this would happen as the effects of a higher dollar impacted the value of international earnings. The management moan appears to be more focused on the rate of dollar appreciation than the rise itself. This is a credible complaint, since a domestic company would find it hard to counter the approximately 8% rise in the greenback during the July through September quarter, followed by another 5% advance during the following quarter. The dollar’s rise from July to the close of trading on Wednesday is an eye-watering 18.6%. In short, the problems US companies are struggling with are not dissimilar to those that Swiss companies are having as a result of the Swiss National Bank abandoning its euro peg. Swiss executives were understandably caught by surprise, and apparently so were US executives. For the Swiss, the surprise came in an overnight announcement by the central bank; for the Americans, it was on display every day as the dollar moved higher. To be sure, the impact of a rising currency will have a much harder impact on the Swiss economy than the US, as 72% of the Swiss economy is export-focused, while only 13% of the US economy relies on exports.
The market consensus of 8% earnings growth for the S&P 500 Index is not reasonable in light of the persistently higher dollar. With roughly 40 to 45% of revenues derived from international operations, earnings were bound to get clipped. A more reasonable target for earnings growth is on the order of 5%. While this is lower than the 6.1% that 2014 is on track to deliver, it still represents growth. The open-ended question remains how much the US consumer’s ruddy optimism, powered by lower energy prices and the stronger purchasing power of a rising currency, will loop back into the earnings stream of companies both large and small.
It is not clear that the rise in the dollar that is fuelled, in part, by the expectation of higher interest rates will be reversed by a postponing of the Federal Reserve’s lifting short-term interest rates. Judging from the Monetary Policy Release from the central bank, the first rate hike in eight years could come as early as June. Given the economic conditions cited in the release, which we have repeatedly noted in these pages, an earlier hike could easily be justified. However, the central bank appears to be stretching out the timing of the first lift as long as possible.
An addendum to last week’s comment on oil
In last week’s In Focus, we laid out what we think is the strategy of the Organization of the Petroleum Exporting Countries’ (OPEC’s) swing producer, Saudi Arabia, to combat excess production in oil markets. We noted that the organization’s Secretary General, while at the World Economic Forum in Davos, quipped that prices will eventually rise. This week, he once again made the comment to reporters at a conference in London suggesting “maybe prices have reached a bottom.” Clearly, Mr. El-Badri is laying the groundwork for a cut to production by the organization. It is hard to see how any cut will be made until we see more hacking away at exploration plans at energy companies. Since OPEC is not scheduled to meet again until June, the earliest a cut could happen in the regular course of business would not be for another five months.
At any rate, the process of crushing the willingness to invest in new projects due to a lack of confidence in the stability of crude prices is not complete…yet.
 Following indexes have been used: S&P 500 Index, Dow Jones Industrial Average Index, Euro Stoxx 50 Index, and Hang Seng Index. Source: Bloomberg, as of January 29, 2015. Past performance does not guarantee future results. An investment cannot be made directly in a market index.
 U.S. Census Bureau/Department of Commerce release of 27 January 2015.
 The Conference Board Consumer Confidence release 27 January 2015.
 Source: Bloomberg, as of September 30, 2014.
 Bloomberg earnings compilations as of 28 January 2015.
 Source: World Bank, as of December 31, 2013.
 Source: Bloomberg, as of January 29, 2015.
 Monetary Policy Release, Federal Reserve Board of Governors 28 January 2015.
 Rebound in Oil Prices likely, says OPEC chief, Financial Times 28 January 2015.
Hans Olsen, CFA Global Head of Investment Strategy