Wednesday, July 24, 2013

What Now?


I have long been a fan of Michael Hartnett, Merrill Lynch's chief global investment strategist.  He was in town yesterday, and with the S&P 500 hovering just below 1700 I was eager to hear his thoughts.

Unfortunately, Michael seemed to be struggling like the rest of us to figure out the next move for the markets.

There is a significant disconnect between the message from the U.S. stock market - which has rallied +50% over the past three years - and the fundamental U.S. economic picture, which is mostly one of tepid growth.

Globally, the picture is not much cheerier. For example, Caterpillar just reported its quarterly earnings, and management commentary was not particularly optimistic.

Here's how the blog Business Insider reported on Cat this morning:

Caterpillar is a global supplier of construction and mining machinery. As such, it's considered to be a reliable bellwether of global economic activity. In other words, what's bad for Caterpillar is good for almost no one.

Among other things, management downgraded its forecast for global growth.
"World economic growth slowed in the first half of the year, and we are revising our growth estimates downwards," they said. "Although we expect some improvement in the second half, the improvement will be less than previously expected. Currently, we expect that world economic growth for 2013 will be a little over 2 percent, slightly slower than in 2012."

Here are some key bullets from their comprehensive economic outlook:
  • In the first half of 2013, industrial production in over half the countries in the world remained below pre-recession peaks and unemployment remained high. These factors have slowed inflation, and we do not expect inflation to be a problem for the world economy in the second half of 2013.
  • We expect weak growth, high unemployment and low inflation will encourage most central banks to continue pro-growth policies. Eighteen central banks cut interest rates this year, reducing average short-term rates to levels lower than 2009. We expect average interest rates to remain near record lows in the second half of the year.
  • Near-zero interest rates are causing some central banks to inject funds (quantitative easing) into financial systems to promote lending and economic growth. Japan recently adopted more aggressive policies, which appear to be effective in improving economic growth. We expect these results will encourage other countries to take similar actions.

Hence the struggle that Michael Hartnett and other global strategists are facing.

Hartnett pointed out that the U.S. market stands alone in having avoided any significant decline in the past couple of years.  Bond prices have fallen in most major markets, and commodity prices have also moved sharply lower from earlier levels.  

Gains in the U.S. stock market have also eclipsed the returns for nearly every other major market over the past three years, as the chart above indicates.

A couple of years ago, Hartnett was one of the few bulls on the U.S. dollar and U.S. stocks.  Now this is the consensus, which is worrisome to him. 

Basically Hartnett argues we are at a crossroads.

One possibility - and the most likely, in his opinion - is that the fledgling economic recovery in the U.S. and Europe gathers momentum.  GDP growth moves sharply higher, and interest rates follow suit. The Fed begins to "taper" its presence in the credit markets, but no one really cares - the economy is doing just fine, even with higher rates. In this case, global stocks continue to do well.

The other possibility is less likely but still very possible, according to Hartnett. If the only reason for the recovery in housing has been central bank intervention, the economy will once again stall.  Interest rates will tumble lower once again, as investors focus on safety, and not total returns.  Stocks in this scenario move sharply lower.

Hartnett thinks that the emerging markets could offer a good trading opportunity for the remainder of the summer. Sentiment is so bearish (see my post yesterday, for example) that any sign of a positive "surprise" could see a sharp rise in emerging markets stocks.  But this would only be a trade - Hartnett feels the fundamentals do not warrant a long-term commitment.

In other words:  Who knows?