In 2014, severe winter weather triggered a downturn in first quarter economic growth before a consumer-led rebound helped the economy reaccelerate. This year, we may be witnessing the same pattern.
At the end of May, Q1 GDP growth was revised lower to -0.7%, driven mainly by trade and inventories. While a noticeable economic acceleration has failed to materialize, we continue to believe that the weakness in first quarter GDP was due to temporary factors. Looking ahead, we believe conditions are set to improve and expect the consumer sector to again lead the way. An improving jobs market, preliminary signs of wage acceleration and still-low gasoline prices should push consumer spending higher. Additionally, we expect the labor market’s contribution to the economy to grow. Also, the fact that the yield curve is not inverted is a sign that the economy should continue to accelerate.
The consumer sector of the economy weakened slightly earlier this year, but we expect that will prove to be a temporary setback. Rising confidence and higher levels of spending should help the economy shift into a higher gear. Overall, we believe the shocks from the first quarter will fade and the U.S. economy should average around 3% growth in 2015.
Outside of the United States, we believe conditions will continue to improve. The decline in oil prices and interest rates that occurred during 2014 appear to be affecting growth positively, and Europe (which has long been a pain point) is finally getting on track. Notwithstanding areas of weakness, especially in China, we believe global economic growth should advance over the rest of this year and into 2016.
Improving U.S. and global growth are positives for equities, but there are some caution signs we are considering. First, we think it will be difficult for equities to make meaningful advances unless and until the earnings backdrop improves. Earnings expectations were revised sharply lower earlier this year, but we think that trend should be changing. As economic growth improves, earnings expectations should rise as well. This should help stock prices break out of the trading ranges in which they have remained for quite some time.
An additional consideration of ours is, of course, the likelihood that the Fed will be raising rates later this year. When discussing the contraction in first-quarter growth, Fed Chair Janet Yellen used the term “transitory” in her speech to the Greater Providence Chamber of Commerce, indicating she expects growth to pick up in the coming months. Moreover, nothing she said indicated that the Fed is shifting its stance. That backdrop, combined with some signs of inflation, suggests that the Fed will indeed be raising rates. We think September is the most likely timeframe for a starting point.
As the Fed approaches liftoff and in the months that follow, we think there is a strong possibility that equities could experience some type of selloff or correction as investors become increasingly nervous about how higher rates will affect the economy and financial markets.
Equity valuations have become moderately expensive as share prices have continued to intermittently advance. Elevated valuations increase the risk that interest rate hikes will cause a valuation “de-rating” and the corresponding drop in prices. This occurred during the rate hike cycles of 1994 and 2004. In our view, however, the combination of improving economic growth and recovering earnings means any correction should be short lived and modest. Moreover, the Fed has been clear that it will remain sensitive to economic and financial conditions and will move carefully and slowly as it pushes rates higher.
In this market, we believe the most prudent course is to maintain exposure to equity markets, ride out any volatility, and continue to maintain a pro-growth investment stance.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of David Abuaf and not necessarily those of RJFS or Raymond James.
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