- 1st quarter GDP growth could be a blowout as low gasoline prices and easy comparisons versus the brutal winter of a year ago provide a robust backdrop to start year.
- Strong start to the year almost assures a June rate hike by the Fed – this isn’t the kiss of death many perceive.
- Europe quantitative easing program almost a certainty given weak Eurozone economy. Japan and China follow suit if their economies don’t pick up for a race to the bottom in devaluing their respective currencies. U.S. still the best place to be.
- Foreign exchange headwinds ($ strength) damper growth expectations, particularly for large caps.
- Be careful what you wish for – oil price decline isn’t all positive.
- Earnings grow 10%+ yielding a stock market appreciation higher than that as P/E’s expand as confidence builds in sustained growth. Looks more like the late 1990’s.
1st Quarter GDP Growth Could Be a Blowout
In four of the past five quarters, GDP growth has averaged 4.5% with the only exception being the first quarter of 2014. For those that need to be reminded, brutal cold and snow engulfed much of the nation for the first several months of 2014 and caused economic growth to come to a standstill. While we can’t predict what the weather will be like in 2015, what happened in 2014 sets up a very easy comparison. Additionally, consumer confidence is growing along with their paychecks as the first real wage increases in years materialize and as more people exit unemployed status. The first two charts below tell the story. Adding fuel to the fire is the decline in the price of gas at the pump. The gasoline futures for January recently pointed to $2.15/gallon at the pump which is down about $1.50/gallon versus a year ago (see third chart below left). According to ISI Group, this decline equates to a $200 billion tax cut. The combinatiion of these factors should set the stage for a potential blowout GDP number in the first quarter as shown in the fourth chart below right, which highlights the relationship between consumer expectations and consumption. If history holds, consumption is poised to accelerate.
Strong Start to 2015 Almost Assures June Fed Rate Hike -- Not the Kiss of Death
Assuming our hypothesis for a strong start to 2015 comes to fruition as laid out above, we believe that the Fed will not hesitate to raise interest rates. The last time that we saw a similar rate hike was in 2004. By the way, the S&P 500 and Russell 2000 finished 2004 up +10.9% and +18.3%, respectively. While many fear a rate hike signals the end of growth for the economy, the data say otherwise and we believe that there are unusual circumstances that make this time significantly different than prior periods. First, Fed Fund rates have been locked at zero for years, and a hike of 50-100 basis points at the short end of the interest rate curve will be barely noticeable. In fact, the one group that might benefit is the banks because the typical loan duration is around three years, and any rate hike will likely steepen the short end of the interest rate curve which is generally favorable for banks. Simultaneously, the 10 year treasury rate could stay relatively constant or possibly even drop if it continues to follow global interest rates lower. The U.S. remains the risk of choice for global asset allocators who prefer the stronger dollar, lower credit risk profile, and higher yields. The chart below shows how the 10 year U.S. Treasury yield has chased the German Bund yield lower over the past few decades.
Secondly, a Fed rate hike would signal their belief that our economy has finally reached escape velocity, and growth can be sustained. This realization may actually be a trigger for P/E multiple expansion for equities. The first chart below shows that the period around initial rate hikes is generally positive for equities. The second chart below shows that while these periods are generally good for equities, they are even better for small cap stocks.
Global QE Programs Attempt to Spur Global Growth – U.S. Still Best Place to Be
Global growth has been weak of late and indications are that Europe will finally pull the trigger on a quantitative easing program early in 2015. The chart below shows how Europe’s growth has decoupled from the U.S. as Russia began their push into Ukraine. Their growth problems are likely tied, in part, to the sanctions being placed on Russia and given that this situation doesn’t appear to be getting any better, Draghi will likely be forced to implement QE. Global stock markets likely respond favorably as it indicates that the ECB is putting in an economic backstop. Japan is all-in on their QE program, and China may follow as their economy also continues to slow.
Strong Dollar May Lead to Growth Headwind as FX Impacts
Since the middle of 2014, the U.S. dollar has appreciated dramatically versus almost any other major currency as global investors take advantage of higher yields, better growth and a lower risk profile versus any other major country. The chart below shows the U.S. dollar’s ascent in the second half of 2014. These trends don’t appear to be abating any time soon so we would expect the U.S. dollar to continue its ascent versus other currencies. This rise will make our goods priced in U.S. dollars overseas more expensive and hence, potentially less competitive and lead to slower revenue growth for those companies that have significant international sales exposure. This effect is much more relevant for large caps than small caps as large caps have significantly more international exposure, which may benefit the relative attractiveness of domestic-focused small caps.
Be Careful What You Wish For -- Oil Price Decline Isn’t All Positive
U.S. consumers may tell you differently, but the epic decline in the price of oil isn’t all good. Here’s why. Over the past five years, the single largest catalyst for U.S. GDP growth, employment, capital spending, and tax revenue has been the “energy renaissance”. Yes, the drop in gasoline prices will add nearly $200 billion to the pocket books of the U.S. consumer, which is a major positive, but the offset is the drop in capital spending, job losses, and revenue from the major slowdown that is under way in the shale regions of the U.S. For example, the Energy sector has accounted for about 12% of total U.S. capital expenditures over the past year. If oil prices stay below $70/barrel for a lengthy period of time, we may see a 30-40% reduction in spending in 2015. We’re not sure that this is currently embedded in expectations. This situation is very fluid as oil’s price decline happened so rapidly and recently that many companies haven’t yet made adjustments to their 2015 budgets in hopes that the drop in the price of oil may be temporary. Put this issue down as one to watch in 2015, but it’s clearly in the negative column for the U.S. economy. The chart below shows the unemployment rate in the two largest oil producing states in the U.S. over the past five years. Note the recent uptick. It’s too early to call this a trend, but it certainly is something worth watching.
Earnings Poised for 10% Growth -- Stocks Follow – Looking Like the Late 1990’s
Earnings are poised to grow nearly ten percent for the S&P 500 companies and significantly faster for the Russell 2000. The table below shows the makeup of the current projected earnings for the Russell 2000. As they always are at this time of year, the estimates are way too high particularly for the Energy sector which could actually be down year-over-year if oil prices remain low.
The chart below shows the relative outperformance that small cap stocks have shown both in terms of earnings and sales growth relative to large caps. A line above the X-axis means that small caps are outgrowing large caps. This trend has been in place over the past couple of years and will likely continue in 2015 given small cap’s domestic focus.
As small cap managers, we tend to look at valuation through a small cap lens. In several past newsletters, we’ve written about valuation and why we think that many are missing the boat by simply quoting a P/E ratio on the broad Russell 2000. We’ve said numerous times that you’ve got to look under the hood at the individual stocks that make up the index. Someone finally did that for us and put the information into the chart below. This chart shows that if you exclude loss-making stocks from the Russell 2000 P/E ratio calculation (green line), the index sports a P/E ratio of a little more than 16 times forward earnings. This value is more or less in line with its level of the past 15 years. Shouldn’t it be higher given where interest rates are relative to the prior years? We think so and that’s why we believe that we may see some P/E expansion to go along with decent earnings growth. This combination offers a pretty compelling return in 2015 for small cap stocks.