The U.S. equity market has come a long way since the depths of the 2008 financial crisis. Since bottoming out in March of 2009, major domestic equity indexes have enjoyed a stellar run-up over the past few years, leading many to question what will keep fueling this bull train once the Federal Reserve starts to shift away from its ultra-accommodative policy.
Recently, we talked with Michael Arone, chief investment strategist for State Street Global Advisors’ US Intermediary Business, about the evolution of the domestic economic recovery.
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Michael Arone shared his insights on what has been driving the recovery thus far, how that is changing, and what it might mean for the investment landscape.
ETF Database: Let’s start by reviewing where we are now. What have been the key price drivers at hand?
Michael Arone (MA): During the last several years, the U.S. Federal Reserve has employed a number of unprecedented monetary policies to keep interest rates at extremely accommodative levels while the U.S. economy healed from the structural wounds inflicted during the global financial crisis. These monetary policies kept interest rates low and the U.S. dollar attractively positioned versus our global trading partners.
In contrast to popular belief, the massive liquidity provided by the U.S. Federal Reserve has resulted in significant inflation – asset price inflation for global stocks, bonds and real estate. Conversely, everyday inflation for items such as wages, commodities, food and energy remain low, even disinflationary.
Up to now the primary beneficiaries of the U.S. economic recovery have been global investors and U.S. corporations.
ETF Database: What evidence do you see that suggests the price drivers are changing?
MA: There are a growing number of signs that the U.S. economic recovery is shifting from Wall Street to Main Street.
Improving employment numbers, a strengthening U.S. dollar and lower gas prices have been bolstering expectations for continued economic growth. U.S. non-farm payrolls have averaged a 200,000+ increase for 10 consecutive months. The unemployment rate has declined 0.8% in 2014 to 5.8%. As the unemployment rate approaches 5.5%, wages are showing some encouraging signs of acceleration. Compensation for private industry workers has increased by 0.4% year-over-year.
The Bloomberg U.S. Dollar Spot Index increased by more than 8% in 2014, making the items we buy from outside the U.S. cheaper.
According to AAA’s Daily Fuel Gauge Report, the national average of a regular tank of gas is $2.76 versus $3.27 a year ago, a decrease of 18.5%. Some analysts are forecasting that a 20% decline in gas prices may lead to $70 billion in consumer savings.
What’s good for the U.S. consumer is good for the economy and the stock market. The consumer makes up about 70% of U.S. GDP and his or her wallet is finally starting to feel fatter than it has in years. The new beneficiary in today’s environment is Main Street, USA.
ETF Database: In your view, what will the price drivers be going forward? How might this impact the investment landscape?
MA: Price-to-earnings multiple expansion will continue to drive stock prices higher in the coming months. Price-to-earnings multiples are cyclical. Throughout much of the ’90s they expanded, admittedly, to unprecedented and unsustainable levels. After the technology, media and telecom bubble burst, not surprisingly, PE multiples contracted for most of the next decade, reaching their nadir during the height of the global financial crisis.
Price-to-earnings cycles are usually measured in years, not months or quarters. The market is only in the early stages of its current multiple expansion which began about three years ago. U.S. dollar strength is good for the economy because it leads to lower import prices and lower commodity inflation. The U.S. dollar and PEs are positively correlated while inflation and PEs are negatively correlated.
Continued U.S. dollar strength and lower inflation will boost PEs and stock prices.
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ETF Database: Which sectors or asset classes do you think are poised to outperform going forward in light of the changes you are seeing?
MA: U.S. equities are likely to outperform in the current environment. The consumer discretionary, technology and financial sectors are also well positioned for gains. If history is any guide, then the retailers, regional banks, transportation and pharmaceutical industries should thrive in these market conditions too.
ETF Database: Broadly speaking, what are some of the biggest trends on the global stage that may further aid the U.S. recovery or derail it?
MA: The U.S. dollar has steadily climbed higher since mid-2011. Economic frailty outside the U.S. likely means more strength lies ahead for the dollar. The combination of a new era of slower emerging markets growth, Abenomics and “whatever it takes” declarations from the European Central Bank are inclined to keep the dollar well bid and extend the U.S. economic recovery.
The Bottom Line
Everyone has been talking about rising rates on the horizon and those with a keen eye have already started to position their portfolios in anticipation of a changing investment landscape. The evolution of the domestic economic recovery will remain in the spotlight as the Fed gears up to start tightening its policy while other major central banks are still very much firmly entrenched in “easing” mode. As such, investors should consider looking into corners of the market that stand to take advantage of the changing price drivers discussed above.
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Disclosure: No positions at time of writing.