03-26-2014 10:59 AM
By John Toohey,
Head of Equities
The first quarter of 2014 wraps up Monday, and we’re still pretty much in the same position as we were back in December — looking for solid signs that the economy is on a path toward recovery and sustainable growth in the quarters ahead.
The next round of corporate earnings reports will begin in a couple of weeks, but results are already being discounted due to the severe winter weather experienced both in places that are accustomed to cold and snow and places that aren’t. Weather was also frequently cited as a business factor during the fourth-quarter 2013 earnings season. Researchers at FactSet report that nearly 40% of the companies in the Standard & Poor’s 500 mentioned weather woes on their earning calls. Given that most of the bad weather has come after the new year, we should not be surprised to see that percentage rise when companies explain the current quarter.
This means in effect that we may not have a clarifying picture of the economy’s overall health and direction for at least another quarter. So we watch and wait.
We’re also watching and waiting to see if the situation in Ukraine worsens. Crimea is securely in Russian hands, and now President Vladimir Putin is building up a large military presence on the eastern flank of the Ukrainian mainland. Is this just an attempt to intimidate the neighborhood, or is he coveting more territory? Is the West going to limit the sanctions for the Crimean takeover to diplomatic shunning, or will it try to hit Russia in the pocketbook? And if the latter, will Russia crimp energy exports to retaliate against the European Union and disrupt or even derail a European recovery that’s just getting its footing?
Watching and waiting also extends to China, which is trying to gently deflate a massive and growing credit bubble. We all know that China has been the world’s main economic engine since the U.S.-led financial crisis in 2007-08, but a lot of the public and private spending there has been done on credit. Estimates peg the amount owed at twice China’s $8 trillion GDP, maybe even more. We saw five years ago what can happen when a credit bubble suddenly bursts; we’re still trying to rebound from such an event. Key differences: China has a huge pile of foreign reserves, and it manages the value of its currency, both of which stand to be advantageous as it works to methodically let the air out of the bubble.
And of course, we’re watching and waiting for the Federal Reserve to show more of its hand on interest rates. At each of its past three meetings, the Fed has reduced its stimulative bond-buying program known as “quantitative easing.” Assuming this pace of unwinding continues at upcoming meetings, QE will be gone by the end of 2014. Fed Chair Janet Yellen let it slip that short-term rates could start climbing six months after the end of QE, which would be sooner than the market has been expecting.
Let’s go back to first-quarter earnings season. Controlling for the weather, we’ll be watching for changes in top-line revenue trends that may indicate that the economy is indeed getting stronger. The current bull market, now early in its sixth year, has been largely driven by the Fed’s easy-money policies and by corporate focus on the cost side of the business. Cutting expenses, increasing productivity and refinancing debt have paid off, but the effect of those measures is nearing exhaustion. Same goes for share repurchases — with markets at near-record levels, there aren’t a lot of bargains remaining for those seeking to do a buyback.
Now we’re seeing an upswing in mergers and acquisitions, which essentially means a company tries to buy revenue growth when it can’t grow the top line organically. M&A is also the last tool in the kit. After this, there are no more moves to be made that can substitute for increasing corporate revenue.
We expect revenue to be marginally better than what we saw in the fourth quarter of 2013. There has been a big pickup in commercial and industrial borrowing, while credit card spending is up modestly. If borrowing continues, it could be telling us that more economic strength is in the offing. We think there is some pent-up demand that may lift the economy a bit, but the activity level will still be short of what the market is hoping for.
We’ve been saying for three years now that we are on the verge of hitting economic “escape velocity.” It has managed to stay frustratingly close for so long without being realized, and we expect the upcoming quarterly results will show that it’s still just beyond our grasp.
USAA Investments Managed Portfolio Outlook
Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. We are also tactically underweight fixed income. We remain slightly overweight cash in our diversified managed portfolios.
We also are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund also provides potential protection against the risks of long-term inflation.
Emerging markets represent another opportunity. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. They offer both an interesting long-term prospect for growth and compelling valuations. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.
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