Impatient Investors Await Policy Responses
By Rich McCloskey, CFA, New Amsterdam Partners LLC, Sub-advisor to Calvert Capital Accumulation Fund
The realization that economic growth was slower than thought, brought on by the gross domestic product (GDP) revisions released last week, combined with the end of fiscal and monetary (QE2) stimulus in the second quarter, seems to have set off the selling in the stock market. Debt ceiling negations, European banking system problems and the Standard & Poor's (S&P) ratings move increased the bearishness. The consensus is revising its GDP outlook lower.
The growth of the U.S. economy in the first half of 2011 was indeed disappointing—partly hampered by Japan’s unfortunate disaster, severe weather in the Midwest and spiking energy prices due to Mideast/North Africa turmoil. Despite this challenging backdrop, corporate profit strength continued in the first half of 2011 and we believe that profits should grow in the second part of the year as the first-half's hurdles recede. Corporate productivity and exposure to emerging economic growth will fuel earnings growth while the domestic economy stagnates.
We are surprised by the market's reaction to S&P’s ratings downgrade, as S&P raised the possibility of a U.S. downgrade months ago and much of the budget issues suggested by the downgrade had been reflected in the market prior to Monday’s selloff. To some extent however, S&P's move is justified in that it speaks to the political dysfunction so conspicuously displayed as political leaders navigated through cantankerous negotiations barely avoiding default. However, relative to the health of many other S&P AAA- rated economies, we feel the decision was somewhat severe although it's entirely possible that downgrades of other sovereign debt may be yet to come.
The biggest impact from the stock market downturn of recent weeks will be to diminish the wealth effect, which could weigh on GDP growth over the next few quarters. Counterbalancing that is the sharp drop in oil prices, off more than $30 per barrel from just a few months ago, which may provide some relief to consumer spending. Japan is in recovery mode and normalizing weather in the Midwest should also help economic growth in the second half. Additionally, the recent spike in the Market Volatility Index (VIX) is similar to levels experienced prior to reaching market bottoms over the past few years, suggesting that the panic selling may be done and the worst may be behind us.
At this point, investors are impatiently waiting to see what foreign and domestic policy responses emerge from the global equity markets' obvious disapproval of the status quo. The markets are pressuring policy makers and the Fed is likely to act, making QE3 more likely. We do not anticipate negative GDP growth but the current slow pace makes it an increasing possibility. All things considered, we do not expect much in the way of market multiple expansion in the near future, but given our expectations for continued corporate profit growth in the second half, and barring further significant multiple contraction, we feel there is more upside opportunity than downside risk at these levels.
Richard McCloskey, CFA, Client Portfolio Manager, received a Bachelor of Arts degree in Economics from the University of Pennsylvania in 1992. He joined New Amsterdam Partners from WestAM, where he focused on Consultant Relations from 2001 to 2005. From 1998 to 2001, Mr. McCloskey was a Senior Consultant Analyst at the Frank Russell Company working with the nation's largest plan sponsors. From 1995 to 1998 he was a Divisional Vice President at PaineWebber where he managed a client service team to PaineWebber's institutional consulting clients. From 1994 to 1995, Mr. McCloskey was a Due Diligence Analyst at DeanWitter, in support of their wrap and managed accounts programs. He began his career in 1992 at SEI Corporation focusing on the client service needs of SEI's traditional consulting clients.
This commentary represents the opinions of its author as of August 9, 2011 and may change based on market and other conditions. The author's opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.
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