This article was prepared by Contango Capital Advisor’s Investment Strategy Group. Contango Capital Advisors is an affiliate of Zions Direct. The Investment Strategy Group provides regular updates on economic and financial conditions.
The US economy has slowed significantly in recent months compared to late 2010 and early 2011. We’re not forecasting a recession … yet. But we are talking about a marked deceleration in the growth rate of our gross domestic product (GDP) – from about 3% in the second half of 2010 to about 2% at best this year.
However, if the huge cuts in government spending now being contemplated in Washington do occur, we could see a recession emerge either late this year or in early 2012. The course of events is likely to be similar to that of the late 1930s, when the government cut spending dramatically after years of fiscal stimulus and thus drove the economy into recession. In 1937, the Dow fell from 180 to 120 – a one-third drop.
US Markets Continue to Fare Well
Despite the economic slowdown and all of the “macro” uncertainty surrounding the economy as a whole, US markets remain reasonably well supported. As of July 25, the Dow was up about 9% for the year, while both the small-cap Russell 2000 and the Nasdaq were up about 7% – certainly decent market returns. We’ve been calling the recent schism between the micro economy – focusing on individuals, households and businesses – and the macro economy “the decoupling of the micro from the macro.” Simply put, although the economy stinks, corporations have, generally speaking, been doing rather well.
Here are reasons for their relative success in an otherwise soggy economy:
—Very low interest rates reduce costs, make more projects profitable, and provide positive operating leverage for a lot of public companies.
—Exposures to fast-growing economies outside the US have helped boost earnings for many companies.
—The weak-dollar policies of the Federal Reserve Board and the Treasury have aided US corporations that operate globally.
—Productivity gains continue to be reasonably strong and corporations have generally been able to grow sales without significant upgrades to plant, equipment and labor.
We’ve already received about half the earnings reports for the second quarter. A lot of big reports came in last week, including earnings from Apple, which once again beat forecasts handily, with earnings 16% above expectations. The key metrics for the second quarter so far are pretty impressive: 18% growth in year-over-year earnings per share (EPS), 13% top-line growth and 0.10% of margin expansion to 8.8%. Some 55% of firms have beat revenue projections so far, which is well above the long-term average of 35%.
We’ve been saying that the biggest risks to the markets, at least through the first half of the year, were related to policy rather than earnings – and that hasn’t changed. So if a major fiscal austerity plan is enacted, it could 1) give a boost to the dollar, which would not be good for the stock market and 2) cause a contraction in the government component of GDP so great that it could drive us into recession.
This means that the best short-term scenario for the markets in our view would actually be relatively modest efforts to curb the deficit this year and next, combined with major long-term structural reforms to the tax code, Social Security and Medicare.
How important has the weak dollar been to US stocks? Well, look at the numbers. Although the Dow is up about 9% on the year, other world markets have been lackluster in 2011. The German DAX is up 6%, the Japanese Nikkei is down about 2%, the UK exchange is flat, and Canada is flat as well. China and Brazil? Down 4% and 13%, respectively. And Germany is probably doing as well as it because of the euro’s global weakness. Certainly, there is no doubt that the weak dollar has bolstered US companies.
Of course, as Americans, it’s unnerving to think that we need a weak dollar to support our markets. However, a weak economy needs pressure-release valves, and currency depreciation is one of those right now. A weak dollar makes our products and services more competitive in the global marketplace. That increased competitiveness is reflected in the great earnings numbers posted by US multinationals so far this year.
We remain mostly fully invested in the majority of client accounts, but we are keeping a finger on the sell button should we see a policy action or mistake that we think would end the party prematurely.
This article was prepared by Contango Capital Advisor’s Investment Strategy Group. Contango Capital Advisors is an affiliate of Zions Direct.
IMPORTANT NOTE: Investment products and services offered through Contango Capital Advisors, Inc. (Contango), a registered investment adviser and a nonbank subsidiary of Zions Bancorporation, are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value of amount invested. Some representatives of Contango are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a non-bank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company (WNTC), a subsidiary of Zions Bank and an affiliate of Contango. CCA#0711-0126