This is one of the quietest, most unloved bull markets we have witnessed. The stock market is at record highs, but no one seems to care. Where prior market records were met with euphoric investors clamoring to invest in stocks, current highs are being met with apathy. Instead of headlines trumpeting investor optimism, we find investors and media pundits are questioning when the market "bubble" will burst. The concern is that the Fed Reserve Board (The Fed) will end the liquidity induced party. The Fed's low interest rate policy is pushing investors towards stocks, given few alternatives that provide attractive returns. After 4 years of steady outflows from stock funds, money is beginning to flow back. This movement towards stocks has the potential to continue for an extended period of time. We recognize that the Fed will have to raise interest rates at some point but we do not believe this will occur in the short-term. The impact on stocks from the inevitable rise in interest rates will be mitigated by both a strengthening economy and improved corporate outlooks.
The Fed's easy money policy is not the only factor driving stocks higher. Concerns weighing on markets in 2012 are beginning to recede. Despite last year's negativity influencing the markets, North American economies still managed to grow. Last year's fiscal crises will not materially impac the global economy going forward as sufficient progress has been made towards resolution.
The US economy appears to be gaining momentum aided by rising auto production and housing activity. We have spoken of the virtuous cycle of increasing activity in these sectors fueling employment growth which cycles back into further demand for these economically important sectors.
These trends should continue for the remainder of the year. The continuing positive data points from the purchasing managers index (an indicator of manufacturing strength) highlights the growth of the manufacturing sector. Buoyed by household wealth recovering to near all time highs, we are also seeing increasing levels of consumer confidence.
While the private sector of the US economy is relatively healthy and gaining strength, the public sector (government) is not as healthy. Federal and State Governments are facing growing deficits and are beginning to restrain, and in some cases, cut spending. As politicians in Washington were not able to reach a deficit reduction agreement, sequestration was implemented to force a reduction in government spending. Sequestration will constrain economic growth, but not enough to offset the positives or damage the recovery.
Stock prices tend to move in sync with earnings. Earnings continue to increase, achieving record levels. With a positive economic outlook, earnings growth should persist. Stock valuations are at a slight discount compared to historical levels based on the Price/Earnings ratio (Chart 1). Stock prices have the potential to increase due to both continued earnings growth and reasonable valuations.
Chart 1: Forward Price / Earnings
Source: JP Morgan
US stocks should continue to outperform Canadian stocks as they have heightened growth opportunities. The US economy appears to be accelerating, while the Canadian economy is slowing. Part of the slowdown is fueled by a pause in the already overheated real estate market. Canadian consumers are more in debt than US consumers were at the beginning of the financial crisis in 2008.
A significant portion of the Canadian stock market is exposed to commodity stocks. These companies benefited from the Chinese infrastructure boom which led to a commodity super cycle. With a pull back in Chinese investment spending, the commodity super cycle appears to have concluded. The next leg of the Chinese growth story is more likely to be led by consumer consumption (where a large number of US companies are well positioned) rather than investment and infrastructure spending.
As previously discussed, we are not overly excited about the bond market. So far this year, this has been the correct call as bonds have returned less than 1%. Assuming GDP growth in North America remains above 2%, bond holders will at best only make the current coupon of 2% - 3%. The risk to bond prices is ultimately to the downside as a strengthening US economy will eventually lead to higher interest rates.
The stock market has moved up almost in a straight line this year. This is obviously not the norm. Typically, there are corrections even as the stock market moves to higher levels. We cannot predict what will precipitate a correction, or even when it will occur, but we assume that the next downdraft will be a short term event. The stock market should continue to move up. We based this on: continuing low interest rates, an improving economy, increasing corporate earnings and undemanding stock valuations. We continue to believe that the US Stock market continues to offer the best potential risk adjusted returns for the remainder of 2013.
