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April 2015
Global Economic Review & Outlook

Fed Patience Likely to Continue into 2016

We believe:

Soft economic data, low inflation, and a strong dollar will cause the Fed to delay hiking U.S. short-term rates until late 2015, at the earliest

Global and U.S. GDP will grow by 2.0-2.5% for 2015

Accommodative monetary policy, M&A activity, and share buybacks will help stocks advance further

I n the U.S., the environment is reminiscent of the growth regime of 1995-1999

Outside the U.S., equity valuations are also attractive, with earnings surprises and economic data contributing to improvements in sentiment

In a slow-growth environment with slowly rising interest rates, convertible securities provide a compelling way to pursue equity upside with potentially reduced downside



FIGURE 1. U.S. DOLLAR AND COMMODITIES: INVERSELY CORRELATED Source: Federal Reserve Bank of St. Louis and Bloomberg.

Entering the second quarter, we remain bullish on equities and particularly growth equities, globally. We believe the slowdown in U.S. job growth, generally lackluster U.S. economic data, low inflation, and a strong dollar will prompt the Federal Reserve to delay increasing short-term interest rates until late 2015, at the earliest. With the first U.S. short-term interest rate hike likely deferred, we expect the euro to stabilize versus the dollar. Similarly, energy and commodity prices could drift higher from here, following the inverse relationship between the dollar and commodities we’ve seen over the past year (Figure 1).

With the Fed taking a patient approach, a stabilizing dollar, and bottoming energy prices, the decline in earnings estimates of the past few weeks should be nearing an end. Although U.S. GDP may only grow by 0.5–1.0% in the first quarter, we still anticipate 2.0–2.5% GDP growth for the year, as well as a resumption of 6–8% S&P 500 earnings growth in 2016. With earnings yields still far in excess of long-term borrowing costs, record M&A and buyback activity will likely continue, providing support to the equity market.

Globally, we expect GDP to expand by 2.0-2.5% for 2015. While economic conditions in Europe and Japan are not as strong in absolute terms as those in the U.S., a string of positive economic surprises has boosted sentiment, and we are seeing encouraging signs of economic inflection points. Valuations are attractive in both regions, as well, as measured by P/Es relative to forward revenue and earnings growth rates.

Market Review

During the first quarter, seesawing investor anxiety fueled volatility. In January and February, investors worried that a rapidly growing U.S. economy would speed the Fed’s timeline for raising short-term rates. In March, investor fears shifted to a slowing U.S. economy and less robust corporate earnings.

Against this backdrop, the S&P 500 Index eked out a 1.0% return (Figure 2). Non-U.S. markets outperformed the U.S. as long-anticipated quantitative easing by the European Central Bank and other positive economic data buoyed sentiment, and the MSCI World ex-U.S. Index gained 4.0%. For the quarter, the U.S. dollar was strong as investors anticipated a rise in short-term rates. There was still money to be made in bonds, with the 10-year U.S. Treasury returning 2.6%.

As we have stated in past commentaries, we believe we have entered a growth regime, and performance during the quarter aligned with our view. In the U.S., growth stocks led value by 460 basis points, a spread not seen since the first quarter of 2009. Within the S&P 500 Index, health care and consumer discretionary led, while utilities, energy and industrials were among the laggards (Figure 3). Outside the U.S., growth stocks also led, albeit by a narrower margin.

FIGURE 2. MARKET RESPONDED FAVORABLY TO FED’S PATIENCE IN 1Q Past performance is no guarantee of future results. Source: Bloomberg.

FIGURE 3. ROTATION TO GROWTH IN 1Q Past performance is no guarantee of future results. Source: Bloomberg.

U.S. Expansion Just Slowing, Not Stopping

Certainly, there are mounting indications that U.S. economic expansion is slowing, including March’s disappointing jobs data, as well as weakness in manufacturing, durable goods, personal spending, housing starts, and exports. Although we believe oil prices can stabilize over the next few months as drilling contracts expire and capital spending cuts are implemented, certain industries and regions tied to the energy sector have started to feel near-term economic pain, which is contributing to overall economic weakness. More broadly across sectors, we expect corporate earnings growth will slow as a strong dollar makes overseas sales less profitable for U.S. multinationals.

However, we don’t believe we are in any danger of a recession, with accommodative monetary policy providing a tailwind for the economy. The Fed can bide its time because inflation is not a problem. At 1.7%, the core year-over-year CPI is below the Fed’s target of 2.0%, while Chair Yellen’s preferred inflation measure, the core PCE Deflator, is even lower at 1.4% (Figure 4).

We expect that the yield of the 10-year U.S. Treasury may continue to fall, as the Fed’s forbearance on short-term rates contributes to the stabilization of the dollar while the ECB’s aggressive stimulus pushes yields lower in the euro zone (Figure 5).

FIGURE 4. LOW INFLATION GIVES FED REASON TO WAIT Source: Bureau of Labor Statistics and Federal Reserve Bank of St. Louis.


Bullish on Equities

Despite our increased caution about the U.S. economy in the near term, the six-year bull market still has room to run. In addition to an accommodative Fed, the economy is benefiting from a “wealth effect” with equity market gains and rising home prices contributing to consumer confidence. Although a strong dollar may clip corporate profit growth, the market looks to have already priced in most of this impact. Earnings estimates have come down a bit—due in large measure to declines associated with the energy sector—but should resume solid year-over-year growth (Figure 6) by the time we enter 4Q 2015.

By our favored measures, equities’ earnings yields remain extremely compelling relative to U.S. Treasury bonds and inflation. As measured by data since the 1950s, the current 390 basis point spread between S&P 500 earnings yields and Treasury yields places equity valuations in the cheapest quartile (Figure 7).

FIGURE 6. U.S. CORPORATE EARNINGS SHOULD RESUME GROWTH BY YEAR END Past performance is no guarantee of future results. Source: ISI.

FIGURE 7. EQUITY VALUATIONS ATTRACTIVE VS BONDS Source: Standard and Poor’s, Corporate Reports, Empirical Research Partners Analysis.

We expect merger-and-acquisition and share buyback activity to remain robust as companies take advantage of low corporate borrowing costs and high earnings yields, and this activity can provide a floor to the equity markets during periods of volatility. We continue to see the prices of the acquiring company’s stock rise, as well.

We remain especially bullish on growth stocks and believe they can perform well as earnings growth slows but remains solidly positive and corporate earnings continue to expand, even at a slower rate year over year. As the European Central Bank’s quantitative easing takes hold, we expect long-term U.S. yields will continue to follow euro zone rates downward, and growth equities have performed well when long-term rates have been low. Indeed, we believe we are in a growth regime similar to 1995 to 1999. Then as now, we had a flattening yield curve (Figure 8) off a low base, narrow valuation spreads, high cash levels, low inflation, and high innovation and disruption.

We do not believe growth stocks are overvalued on the whole. The premium for large cap growth over large cap value is 1.2x, less than the 1.4x average since 1990 and well less than the 3.0x level of the tech bubble (Figure 9). In this environment, we are favoring a balance of secular and cyclical growth, overweighting technology, health care and consumer discretionary, while underweighting energy, materials and commodities.


FIGURE 9. THE PREMIUM FOR GROWTH IS LOW Past performance is no guarantee of future results. Source: FactSet (1989-6/2012) and CapIQ (7/2012-present).

Non-U.S. Opportunities are Growing

As well as maintaining a bullish outlook for U.S. equities, we’re identifying significant opportunities outside of the United States, supported by more attractive valuations, increasingly accommodative monetary policy and economic fundamentals that have strengthened or surprised to the upside. From a regional standpoint, we are most constructive on Europe and Japan, while maintaining a more select approach to emerging markets.

Europe. Europe’s equity market is trading at a slight discount to the U.S. on a multiple basis, but earnings and revenue growth for companies in Europe are expected to exceed that of U.S. companies (Figure 10). Although the U.S. economy remains stronger in absolute terms, expectations have been lower for Europe and we have lately seen a string of positive surprises (Figure 11), which have contributed to improved sentiment about the region.

Although Europe has performed well year to date (Figure 12), we don’t believe the market is overheating.In our view, the most significant catalyst is the massive quantitative easing implemented by the European Central Bank, which has pushed rates lower and weakened the euro. While we remain cautious of QE’s ability to jumpstart the economy without increased structural reforms, we believe QE creates a reflationary catalyst for select businesses benefiting from policy decisions. We were positioned ahead of QE, and continue to find investable opportunities among exporters, multinationals, reflationary plays, and higher dividend yield companies.



FIGURE 12. GLOBAL EQUITIES SHOW MOMENTUM Past performance is no guarantee of future results. Source: Bloomberg.

FIGURE 13. JAPAN: STRUCTURAL REFORMS PROVIDE A CATALYST FOR STOCK BUYBACKS Source:. J.P. Morgan, “Japan Equity Strategy,” February 3, 2015, using data from Bloomberg and J.P. Morgan.

Japan. Japan is benefiting from similarly accommodative monetary policy and sentiment has improved after the Bank of Japan surprised markets with the aggressiveness of its most recent stimulus. On the basis of P/E ratios, valuations in Japan are even cheaper than in Europe, with expectations for stronger earnings and revenue growth over the next two years. Economic data has been mixed to stable, but we are seeing individual companies surprise with improved capital allocation and more shareholder-friendly policies. As we discussed in a recent blog, the introduction of the Nikkei 400 Index has encouraged companies to improve return on equity (a requirement for inclusion in the index). We’ve seen an increase in stock buybacks (Figure 13), dividend increases, and capital expenditures. Against this backdrop, we believe Japan’s market can advance further, although a bottom-up approach remains paramount.

Emerging Markets. While we maintain high conviction in the long-term secular growth themes related to emerging markets, we are taking a selective approach to emerging economies in this environment. Economic growth remains challenged in a number of countries, with quality companies (that is, those with strong balance sheets and sustainable growth) harder to come by. We expect a divergence in the near-term prospects of emerging market economies, due to declining commodity prices and different structural reform trajectories. We have favored commodity consumers as commodity prices have fallen, in turn reducing inflationary pressure and providing room for some countries to implement accommodative monetary policy.

We remain positive on India and China. Falling energy prices have allowed the Reserve Bank of India to become more accommodative, while Prime Minister Modi has engendered optimism around economic reforms. In regard to China, recent policy changes have had an impact on both volatility and returns in the equity markets, but we believe many companies can benefit from reform initiatives as well as from the country’s growth potential. Still, we remain disciplined on valuations, given the appreciation in the market as a whole and the volatility over recent years.

Our team continues to identify investments in the Philippines, one of the faster growing emerging markets even prior to the economic tailwind of falling commodity prices. Valuations are more full relative to some other emerging markets, but we are finding bottom-up opportunities that we believe are positioned to benefit from the Philippines’ economic growth potential.

While we still find many companies that meet our criteria within Mexico, we are becoming more cautious as we move through the current election cycle. While structural reforms and ties to the U.S. economy have provided tailwinds, we are mindful that the recent fall in oil prices may create budget pressures that will impact the consumer in 2016.

The Case for Convertibles

Convertible securities have tended to perform well in a slow-growth environment, when stocks are rising and interest rates are increasing slowly. Convertibles can also benefit from market volatility, as their embedded option can become more valuable. Against this backdrop, we believe the benefits of convertible securities are especially pronounced. Because convertibles combine equity and fixed income characteristics, they offer the opportunity for upside equity participation with potential downside protection when equity markets decline.

Valuations are attractive and our team is finding many securities that meet our criteria. More specifically, we seek out issues that offer higher skew on the upside. To identify these securities, we combine our proprietary credit research (given our emphasis on downside resilience) and equity analysis (to secure a healthy measure of equity upside).

Our team has been encouraged by the brisk issuance we have seen so far in 2015, the terms of issuance, and the diversity among issuers. As Figure 14 shows, issuance has been on the upswing over the past two years and is running at an even more robust clip during the first quarter. From a sector perspective, health care, financials, technology and energy have been well represented. From a regional perspective, U.S. issuance of $16 billion is particularly notable as is the surge in European issuance seen in March. We’ve also seen companies choose to issue mandatory convertibles. (As their name suggests, these securities have a required conversion date and typically offer higher coupons, which may make them compelling for income-oriented investors concerned about an eventual rise in short-term rates.)


We expect convertible issuance to benefit from a slow-growth environment, as well as from the slowly rising interest rate backdrop we expect. For example, in addition to benefiting the equity markets, high levels of M&A activity will likely contribute to increased convertible issuance as companies seek to offset the cash outflows associated with large acquisitions. While we are optimistic about issuance prospects across sectors, we would not be surprised to see especially strong issuance within the energy sector. When a sector experiences a period of duress and dislocation (as energy has), the convertible market typically opens up to companies seeking capital before the non-convertible bond market does.


2015 YEAR-END S&P 500 OUTLOOK Source: BofA ML Global Research.

We believe the U.S. economy should be able to regain its footing from a weaker first quarter, with GDP growth in the 2.0-2.5% range for 2015. Bad economic news—provided that it’s not too bad—can continue to be good news for stocks. As an accommodative Fed, M&A and buyback activity, stabilization of the dollar and oil prices, and still-solid corporate earnings growth offset weakness in the energy sector and related industries, we believe the S&P 500 Index can return more than 10% for 2015.

Meanwhile, in Europe and Japan, good economic news has been good news for stocks and we are hopeful that can continue. While sustainable and robust recovery in Europe will require more structural reforms, we view QE as an important step and are also encouraged by the concerted and coordinated efforts we have seen in Japan. Emerging markets will continue to require a selective approach against a backdrop of falling commodity prices and varying economic reform outlooks.

Given our expectation for slow global growth, and volatile but advancing equity markets, we believe the case for convertibles remains strong. In this environment, convertibles can benefit from their equity sensitivity as well as the downside protection their fixed income characteristics provide.