Finding the Short-Term Tailwinds

The long-term economic and market picture still isn’t an attractive one. Many shorter-term trends, however, are positive. Too many investors and analysts are missing opportunities because they are worried about the long-term, how the presidential election might affect markets and other noise. The things that really matter to markets are pointing to several opportunities.

The U.S. economy continues to perk along at about the average rate of growth it has had in this recovery. There are ups and downs in the monthly data, and analysts generally over-react to the periodic negative surprises. In fact, the reliable indicators of impending recessions (real retail sales, the unemployment rate) are solidly positive.

Household income continues its steady, unspectacular growth. The low unemployment rate and reasonable rate of new job creation are putting upward pressure on wages, and that should further boost household incomes. Low gasoline prices, low interest rates, higher stock prices and rising home prices combine to improve household finances and stimulate demand.

These factors are reflected in the consumer sentiment surveys. The surveys have been consistently strong the last few years, and the latest ones reported increases in confidence. The consumer sentiment surveys usually are good indicators of the path of retail sales and household demand in the coming months.

The service sector of the economy paused during the summer, but it appears to be improving again. Manufacturing, which has been in a depression since late 2014, appears to be at or nearing its low point now that energy prices are higher and exports are starting to increase.

An important trend is that business core investment had solid increases the last three months. That indicates businesses might be recognizing the strength of household demand, and the businesses might be investing to meet that demand.

Inflation has been stable to rising through 2016 and now is just a little below the Fed’s target. Market prices consistently indicated all year that investors expect little to no inflation the next few years. I expect that inflation will surprise investors by rising more than expectations.

Major U.S. stock indexes are likely to lag the economy for a while. Corporate profit margins are shrinking, thanks to lower productivity, higher wages and higher commodity prices. Earnings for the S&P 500 have been lower on a 12-month basis for seven consecutive quarters. In addition, the financial engineering that’s supported stock prices is coming to a close. Businesses have reached their capacity to borrow to pay dividends, buy back stocks and merge with other businesses.

There are better stock opportunities outside of the United States.

Emerging markets were very undervalued in 2015 and early 2016. They’d been in a bear market for several years because of falling commodity prices and lower growth in China. Emerging markets have been bouncing back this year, but many still sell at low valuations both historically and relative to the United States. There are some emerging economies with serious problems, but overall the emerging markets present good opportunities for U.S. investors.

European stocks also are more attractive than most investors realize. U.S. stocks substantially outperformed European counterparts since the European crisis of a few years ago, but factors are changing. The European Central Bank’s (ECB) monetary easing provides some stimulus to the European economy. Also, European companies benefit more from higher growth in the emerging economies than U.S. companies do.

Earnings growth for European companies now is substantially higher than it is for U.S. companies. That’s likely to continue, and investors don’t realize it. Europe still has a lot of unemployed, so there isn’t much upward pressure on wages. The euro also is likely to be stable or decline, because of the ECB’s policies. That helps European exporters.

As always, we focus not only on current trends and how those trends might likely change. We also look at what’s already priced into the markets. Early this year, investors clearly expected more of what we’d seen the previous few years: very low interest rates and inflation and modest economic growth. A strong consensus like that creates too much risk in investments that are likely to benefit from the consensus outlook and not much potential return. That’s why earlier in 2016, we sold investments likely to benefit from falling interest rates and inflation, such as long-term treasury bonds and utility stocks.

We’re always looking for a margin of safety in our portfolios. We need that more than ever now, because there’s far more risk than potential reward in many markets.