The answer to the title is a resounding yes. The strong North American stock markets during the third quarter (S&P 500 in Canadian dollars + 2.5%, S&P / TSX Composite +5.4%) were related to improving Chinese and European economic data. As a reminder, the 2012 economic data showed signs of a Chinese slowdown (due to declining exports) and a continuing European recession. Recently, reports have highlighted stabilization in the European economies and acceleration of the Chinese economy. This renewed acceleration of global growth is positive for equity markets.
The recent Purchasing Managers Index (PMI) reports lead us to conclude that the European economy is bottoming and the Chinese economy is growing again. The PMI is a leading indicator for what is transpiring in the manufacturing sector. A PMI above 50% indicates that manufacturing sentiment is growing, while a reading below 50% implies that manufacturing is contracting. The blue line in chart 1 demonstrates the European Purchasing Managers Index (PMI) crossing above 50%. The black line in chart 1 tracks the growth of the Euro zone economies. This line is approaching zero, indicating that Europe is finally recovering from a deep and protracted recession.
The recent Purchasing Managers Index (PMI) reports lead us to conclude that the European economy is bottoming and the Chinese economy is growing again. The PMI is a leading indicator for what is transpiring in the manufacturing sector. A PMI above 50% indicates that manufacturing sentiment is growing, while a reading below 50% implies that manufacturing is contracting. The blue line in chart 1 demonstrates the European Purchasing Managers Index (PMI) crossing above 50%. The black line in chart 1 tracks the growth of the Euro zone economies. This line is approaching zero, indicating that Europe is finally recovering from a deep and protracted recession.
Chart 1: Leading indicator (PMI) points to improving domestic demand growth in Europe
Source: Thomson Reuters, Credit Suisse Research
Chart 2: Recent PMI new orders suggest improvement in Chinese GDP growth
Source: Credit Suisse
At the September 18th meeting, The Fed surprised the financial markets by announcing that there would be no changes in their quantitative easing program. They re-iterated that any pullback in bond purchases would be data dependent. The Fed Chairman opined that the data did not support a taper at the current time. When mentioning data, they are specifically referring to employment data, as the Fed has a dual mandate that takes into consideration both growth (which has been ok, but not great) and employment (improving but still tepid as of the August report). Some investors speculated that The Fed did not want to taper the bond buying program in advance of the looming debt ceiling debate in Washington.
Whatever the reasons for their inaction at the September meeting, it resulted in interest rates declining across the yield curve. Ten year government bond yields backed off to 2.6% and bond prices recovered some of their summer losses. Low interest rates will continue to provide support for rate sensitive portions of the economy such as autos and housing.
Another benefit of the Fed's ongoing quantitative easing program and continued low interest rates is the positive influence on stock and house prices. When asset prices increase in value, consumers feel more confident about their financial well being, even without an increase in income levels. With the stock market indices hitting record highs and housing prices in most markets recovering to pre recession levels, consumers are feeling wealthier. This positive confidence ultimately translates into increased consumer spending, providing a boost to the economy. This "Wealth Effect" creates a positive feedback loop. Heightened economic activity translates into higher incomes, increased consumer demand and business investment.
The US economy continues to grow. While 2.0 - 2.5% growth does not appear to be strong relative to prior recoveries, the private sector is growing in excess of 2.5%. A shrinking government sector is holding back the growth numbers for the overall economy. Stabilization of the government sector of the economy should result in higher growth rates for the entire economy.
We anticipate with a strengthening economy, The Fed will begin tapering their bond buying program at some point in the near future. Even with the recent rise in interest rates, the bond markets remain in a low rate environment, with yields of less than 3%. The bottom for interest rates in this cycle is behind us. We are transitioning from a declining rate environment to a rising rate environment. This means that bond returns are likely to be less than the current meagre dividend yields. The bond market will be a tough place to make money and invest over the next few years.
In our last commentary, we discussed plausible year end targets for the S&P 500. After a great third quarter, we are over half way to our December 2013 target. While upside of 3% may not appear material, it is still attractive compared to 2.6% bond yields. The potential exists for more gains in 2014 based on the same exercise we did last quarter. An S&P 500 target of 1880 for year end 2014 is achievable if we assume the index trades at 16 times trailing earnings, which is its historical average. This implies US stock market returns in excess of 10% between now and the end of 2014.
Clearly we find stocks more attractive than bonds, especially when considering that we are nearing the end of the current interest rate cycle of declining rates. Interest rates have begun to moving up, and will continue rising over time. In this scenario, bonds are likely to have a difficult time returning much more than their current low single digit yields. Stocks on the other hand offer potential for double digits gains over the next five quarters, with dividend yields that are similar to bond yields. Dividend payouts should continue rising as company profits are at record levels and corporate balance sheets are flush with cash. This will provide further support for continued stock price gains.
The most important factor for our conclusion that stocks will outperform bonds goes back to the rising interest rate scenario. Rising interest rates are typically bad for bonds but good for stocks, especially if the rate increase is due to an improving economy. While the Fed might not have enough data at the current time to support pulling back on their bond buying program, the financial markets are anticipating that it will occur. The other key factor is the improving economic data from Europe, China and the improving US auto and housing markets. Our conclusion is economic growth is picking up, which will result in a cycle of rising interest rates and stock prices.
