If there’s any doubt summer is over, take a look at Wall Street.
The major indexes are rallying to record or multiyear highs after faltering in June and July.
Three months ago, rising energy costs and interest rates were like ants at a summer picnic.
Now all of that has changed.
A barrel of crude oil has fallen nearly $15 from mid-July when it traded at a record high of $78 as Middle East tensions were on the rise. Interest rates, which have steadily risen over a two-and-a-half year period to 5.25%, have leveled off.
Economists see rates unchanged through mid-2007 before they could fall slightly. The economy is set to slow next year, but some believe the U.S. may dodge the recession bullet.
The housing boom is slowing, but few fear the type of crash we saw in the early 1990s.
There’s still a lot to worry about.
Corporate America is about to weigh in with earnings for the recently ended quarter. The world isn’t any safer with North Korea’s reported nuclear test and lingering troubles in Iran, Iraq and Afghanistan.
The Business Journal canvassed money managers to gauge their outlooks and where they’re directing clients’ money.
We asked four questions: Is a recession a possibility next year? What is your outlook for the stock market next year? What sectors will perform best? What is your outlook on interest rates?
Responses are varied. Some are more optimistic than others. Following are edited responses to the Business Journal’s questions.
Is a recession a possibility next year? If so, what will it mean for the markets?
Chuck Martin
Chairman, founder
Mont Pelerin Capital LLC,
Newport Beach
A recession next year is an extremely remote possibility. Our economy is doing fine, though its high growth rate is slowing. We have a full employment economy, relatively benign inflation, low interest rates, strong consumer demand, businesses with strong balance sheets and a healthy pace of investment. In the unlikely event of a recession, obviously the stock market would go down and interest rates would decline.
Matt Healy
Senior regional investment manager,
senior vice president
Wells Fargo Private Asset Management Group,
We are anticipating a soft landing for the economy as economic activity slows. The reality for the consumer is that high gas prices have taken a bite out of personal income. However, for the economy as a whole, the U.S. has become much more service oriented and consumes much less oil as a percentage of GDP than it has previously. This helps.
Certainly, higher oil and commodities prices are beginning to drive up consumer prices. However, core inflation running at 2.4% annualized still is below its historical median of 2.9%. Similarly, interest rates may be on the rise from their near depression-like levels of a couple of years ago. However, by historical standards, they are relatively benign considering the median 10-year Treasury yield from 1957 to 2005 has been 6.5% versus 4.7% today.
Corporate balance sheets are very healthy and companies have plenty of cash to invest. Corporate earnings have been very strong. In fact, the S & P; 500 has had 17 consecutive quarters of double-digit, year-over-year quarterly earnings growth. There have been only three times in the post World War II era where there have been more than 10 consecutive quarters of double-digit, year-over-year quarterly earnings growth. Finally, national unemployment at 4.7% remains well below the long-term historical mean of 6%. In summary, the economy is likely to experience a soft landing.
Michael Johnston
Managing director, wealth management
Senior adviser, private wealth management
Smith Barney Inc., Irvine
While a recession next year is possible, Citigroup does not view it as a likely scenario. Some investors will point to the inverted yield curve as a signal that the market is predicting a recession. This is a result of the notion that ongoing weakness in the economy will reduce inflationary concerns, providing the Fed with room to ease dramatically, thus driving short-term rates lower.
However, because rates on longer maturities are more dependent on supply and demand forces, we believe that the current inverted yield curve is the result of too much cash chasing too few bonds on the longer end of the curve. This results in driving prices up and yields down (yields move inversely with bond prices).
Growth so far this year has been resilient, supported in part by the boost to economic activity from the rebuilding after Hurricane Katrina. The first quarter recorded an expansion of 3.7% versus the first quarter of 2005. The second quarter rose 3.5% from the same period in the previous year.
We believe that the current Fed Funds rate of 5.25% is a neutral rate,neither inflationary nor restrictive. And while growth likely will be slower in the second half, it will still average 3.5% for the year and 2.8% throughout 2007. While a 2.8% growth rate is slower than the past few years, historically, this would be considered a rather robust level.
If there was to be a recession (and we remind you that we do not believe that this will occur), our firm believes that the effects on the equity markets would unfold as follows: The Fed’s tightening efforts succeed too well causing economic activity to slow and depressing corporate earnings. At the same time as corporate pricing power wanes, profits are threatened by rising labor costs and higher prices for energy and transportation. The negative effects of the cool down in the housing market and the high energy prices restrict the ability of companies to pass along rising costs to consumers. As one would imagine, the equity markets do not typically perform well during a recession. Citigroup’s research shows that in three out of four recessions that followed the peaks in rates between 1970 and 2002, the S & P; 500 declined over the following six months, and also declined over the following 12 months in two cases.
Jodi Rolland
Regional managing director,
Southern California
Merrill Lynch & Co.,
Newport Beach
According to our Merrill Lynch analysts, the much-vaunted housing market correction, which has finally hit the U.S. economy, has the potential to pull the U.S. to the brink of recession by early 2007 (based on the Fed’s model, the odds of a recession in the coming year is 45%). The combination of the decline in home prices and the slowing in the growth of housing stock is expected to reduce housing wealth by more than $1 trillion in 2007. This, in turn, will likely mean that consumers will spend 1% less for most of next year and double that figure if the fall in housing prices are more severe.
Our overall view remains that while we could see some weakness in equities over the short-term as the effects of softer economic activity and slowing earnings growth work their way through the system. Our longer-term outlook for equities remains positive.
Donald H. Straszheim
Vice chairman
Roth Capital Partners LLC,
A U.S. recession in 2007 is very unlikely at this point. Unemploy-ment is still low at 4.7%. Most people that have any job skills can find a job. (Note: This is striking and a strong endorsement of the U.S. economy given the high-profile issues of massive imports from China and elsewhere, and still high immigration from Mexico).
Inflation is still well contained. Equities are doing better with the Dow having made an all-time high. Oil prices are down a lot, helping consumer and business attitudes and lifting real discretionary incomes. Lastly, housing prices are down. But mortgage rates are down as well, already giving a lift to the housing sector via improved affordability.
Globally, China and India remain strong and the developed markets (Japan, UK, Europe, Canada and Australia) are also growing at a decent pace. These are just not the preconditions of recession.
But if recession does develop, the U.S. equity markets will suffer considerably,especially because the consensus view does not contemplate a downturn.
When will the next recession come? Try 2015. We had eight recessions in 33 years, from 1949 to 1982. Then a nine-year long expansion, 1982 to 1991. Then again a 10-year long expansion, 1991 to 2001. And now another five-year long recovery with no end in sight. For many reasons, the economy has changed structurally a great deal and is simply not as cyclical as in the earlier postwar years.
Joseph Quinlan
Chief market strategist,
Global wealth & investment management
Bank of America Corp.,
New York
A U.S. recession is possible next year, but not part of our forecast. Economic growth will slow in 2007, not stall.
Relatively strong corporate spending and robust exports will offset the slowdown in housing, and, by association, personal consumption. Also supporting U.S. growth will be strong demand outside the U.S., with the global economy expected to expand by 3.8% in 2007. In the U.S., we expect real growth of 2.8% for 2007, with inflation averaging 2.5% over the year.
What is your outlook for public equity markets next year?
Martin of Mont Pelerin
Last year, when I was asked about 2006, I expressed the opinion that the markets would go mostly sideways in a plus or minus range of about 5%, but would be highly erratic. This year the S & P; 500 is up 5.3% and has certainly been volatile, with a 30-day swing down of 8.5% and a 30-day upswing of 6.4%. We will see what the rest of the year brings.
This coming year the market is expecting a slowing economy, but some modest continued growth. I see it the same way. I expect the market to move generally sideways, perhaps a little up. When asked for a prediction, I would forecast it to be up about 5%, but with a wide range of volatility, in the plus or minus 7% range.
The volatility will continue as the market’s psychotic behavior struggles to deal with big macro considerations such as fluctuating energy prices, terrorism and geopolitical problems. During the second half it will move based on expectations for 2008. That picture is harder to see. Assuming no large-scale macro events occur, the world’s economies (and ours) should continue slow, steady growth. However, we live in an increasingly dangerous world, driven by the rise of terrorism, geopolitical unrest and strong growing Anti-American sentiment.
America’s effort to bring stable democracies to the Middle East is seriously at risk of failure (Iraq, Afghanistan, Lebanon, Israel, etc.). Our nation’s efforts are compromised by the fact that our presence there is unwelcome and it is easy for our detractors to put a negative “spin” on our motives.
Israel’s failure to succeed against Hezbollah poses a huge threat to stability in that region as activist Arab nations and Iran have become emboldened. This is very dangerous as they may escalate initiatives against Israel. Then what does the U.S. do? It is a very worrisome situation.
Healy of Wells Fargo
Both the stock and bond market have followed a seesaw pattern of advance. Currently, the stock market is recovering from its fifth temporary sell-off of the recovery. Since the bull cycle began in early 2003, a similar cycle has repeated. Stock market rallies are followed by spurts in bond yields, followed by stock market pullbacks producing a decline in bond yields, leading to another stock market spurt. The stock market is currently trading at a price-to-earnings multiple of 16 times (close to its historical average) based on 2006 consensus earnings estimates and 15 times 2007 estimates.
Yet we are in an environment with low historical interest rates, low historical inflation, strong corporate earnings and tremendous corporate liquidity. We currently favor stocks over bonds and would recommend clients to continue to look for higher prices for stocks in general.
Johnston of Smith Barney
Tobias Levkovich, our chief equity strategist, has recently introduced year-end 2007 targets for the S & P; 500 of 1,500 and the Dow Jones Industrial Average of 12,750. These represent gains of 13.6% and 10.3%, respectively, from mid-September levels. Citigroup arrived at these targets using a number of methodologies including valuation, earnings, and investor sentiment.
Our economist, Steven Wieting, predicts that operating earnings for the S & P; 500 will climb 15.4% for 2006 and then slow to a growth rate of 7.4% for 2007. While this does represent a slowdown, it is still a healthy growth rate, which, if the market price and earnings ratio stayed at a constant level, would equate to a return on the S & P; 500 of 7.4% for 2007.
The major risks to the equity markets over the next year include energy supply disruptions, economic nationalism and protectionism, unanticipated inflation, and a sharp decline in the value of the U.S. dollar.
Rolland of Merrill Lynch
While I cannot address market index predictions specifically, we advise our clients that it is important to stay invested in the market for the long-term.
According to Rich Bernstein, chief investment strategist at Merrill Lynch, the 12-month expected price return for the S & P; 500 is 1%. The level of precision of our models is spurious, but he is generally forecasting single digit returns for the S & P; 500.
Straszheim of Roth Capital
Stock market averages ought to have an upward bias, perhaps by 10% to 12%. If real GDP growth is 3%, and inflation is 2.5%, corporate earnings per share in quality equities ought to be up about 8% at a minimum.
And if inflation and interest rates behave, which seems likely under these circumstances, price-to-earnings ratios should expand, making 10% to 12% quite realistic.
It is worth remembering that corporate balance sheets have been considerably repaired in the five years since the 2001 recession and the dot-com meltdown. And the buildup in liquidity that the Fed engineered after the 2001 recession and the attacks of Sept. 11 leaves investors quite able to drive further equity gains.
Quinlan of Bank of America
We expect the major indices to be higher a year from now, but not by much. We are looking for roughly 5% to 7% upside from where the Dow and S & P; are today. Perhaps a little higher for the Nasdaq on the assumption of strong corporate spending in the U.S. and rising global demand for information technology products and services.
What sectors will perform best?
Martin of Mont Pelerin
I do not see any clear sector winners or losers next year. However, there will continue to be individual companies that will prosper and others that will falter. Certainly one must be reserved about investing in housing, construction, building materials and mortgage finance companies, since they are certainly headed lower next year. Energy and other consumer commodities will be volatile and unpredictable.
Healy of Wells Fargo
Currently, we favor large company stocks over small company stocks with an emphasis on higher dividend paying entities. We also recommend investors to have a significant exposure to international equities. Our current style allocation recommendation for equities is 55% large cap, 12% mid cap, 8% small cap, 20% international-developed and 5% international-emerging markets.
In terms of our sector strategy we are recommending an overweight in industrials, information technology and basic materials.
Johnston of Smith Barney
In terms of industry sectors, we favor consumer discretionary areas due to the attractive valuation, rising earnings estimate revisions and improving fundamentals of the media subsector; healthcare due to the attractive valuation and dividend yields, improving pricing power, out of favor status with sell-side analysts and risks being reflected in the current stock prices; information technology due to favorable earnings estimate revisions, neutral valuations, and solid capital expenditure expectations; and telecommunications services due to improvements in pricing, rising estimate revisions and neutral valuations.
Rolland of Merrill Lynch
Our U.S. sector strategist overweights industrials and telecom services and underweights utilities.
If the history of presidential election cycles is any guide, we may be in for some strength in the equity markets over the next couple of years.
The second years of presidential terms historically have been correlated with weak periods in the U.S. stock market, such as we saw earlier this year. Only twice since 1900 have stocks failed to experience a strong rally between the second and fourth years of presidential terms,during Teddy Roosevelt’s second term and during the Great Depression.
Straszheim of Roth Capital
Extending a string of many years, 2007 looks to be another year of superior performance by the smaller stocks than the larger ones. The reason is simple. It is the small companies,not the large ones,that provide the economy with its most important dynamic. They have been growing faster for years. 2007 should be no different.
Quinlan of Bank of America
Best performing sector: technology, notably large cap names. We favor software over hardware and like the networking companies. We also like sectors such as financials, healthcare and the industrials. We are neutral on energy.
What is your outlook on interest rates?
Martin of Mont Pelerin
The oil producing countries and Asia (China, Japan and others) are generating huge surpluses of U.S. dollars because of our huge negative balance of trade with those countries. Because the U.S. is a “safe harbor” and has large, liquid markets, the cash flows back into our system, in large part through the purchase of our debt instruments by those nations. This keeps interest rates low no matter what the Fed does. The simple fact is that today the Fed has little power to control interest rates (except short-term rates.) Consequently, I believe that interest rates are not likely to move higher.
The housing market is already headed into a steep decline. This started in the late summer. Interest rates have little to do with this development. While lower interest rates were the primary engine behind the housing boom over the past many years, it is the end of speculation that is taking the gas out of that engine. In recent years, an unreasonable amount of the housing stock was bought “for investment” purposes, motivated by rising prices. Secondly, many homebuyers bought up more expensive homes than they could reasonably afford because of the plentiful supply of cheap mortgage money and the fear that they would get left out of value appreciation. This could not go on forever. Once the psychology began to turn, housing sales began to slow. Homebuilding companies saw their inventories rise and began forfeiting their option money to “take down” more land for the production of new housing units. So the escalation of home prices is over for now and in many areas we will see declines. It is not that the housing bubble is bursting, but the market will be soft for a while.
Healy of Wells Fargo
Today we have an inverted yield curve that is suggesting future expectations of economic growth and inflation are moderating. The Federal Reserve has stopped tightening monetary policy for the time being and the 10-year treasury yield has declined from recent highs. We anticipate a soft landing for the housing market.
Looking ahead, we feel the majority of the increases in rates are behind us. However, there is still some uncertainty as to what the peak in yields will be. As part of our comfort level that the worst of rate increases is behind us, we will look to make the following moves in the future:
Add duration to accounts that are currently short duration. Purchase additional bonds in the five- to 10-year part of the yield curve.
Reduce high levels of high-yield bonds or individual bonds of lower quality. Look to add fixed-rate preferred stocks.
Municipal bonds have held their value relative to other bonds and look for opportunities in this market.
Johnston of Smith Barney
The Federal Reserve’s Federal Open Market Committee concluded last month that monetary policy may be constraining financial conditions sufficiently to foster a slowdown in growth and contain inflation. Michael Brandeis, our senior fixed-income strategist, believes that the Fed has finished raising short-term interest rates. We predict that the Fed funds rate will remain at 5.25% at least through the second quarter of 2007.
On the longer end of the curve, Citigroup believes that long-term rates have also peaked. Longer-term rates are dictated by prevailing market conditions as opposed to the Fed and these conditions suggest that inflation pressures should be well contained and probably recede in the coming quarters. Citigroup predicts the 10-year Treasury to trade in the 4.9% range through at least the second quarter of 2007. This will result in the continuation of the yield-curve inversion (where short-term rates are higher than long-term rates).
The lack of upward pressure on long-term rates (represented by the yield-curve inversion) reflects the ongoing faith that the Fed has the intention to do what is needed to bring inflation down to a level that both the Fed and the markets are comfortable with. This confidence in the Fed is a positive for the equity markets because the markets dislike uncertainty. If the Fed has finished this tightening cycle, this would be a positive for the equity markets. Historically, the U.S. stock market tends to perform well after the Fed ends a rate-tightening campaign.
Rolland of Merrill Lynch
The Fed reiterated its concerns about inflation, but also acknowledged the reality of weakening economic growth. At this point, Fed Funds futures have begun to suggest that the Fed is likely to start easing monetary policy in early 2007, alongside our expected slowing in economic growth and easing inflationary pressures.
Our economists expect the Fed to lower interest rates by 125 basis points in 2007. Broadly speaking, Merrill Lynch would advise overweighting the fixed-income markets of the U.S., Canada, Australia and underweighting Japan and the Euro area.
In our view, the combination of a slowing economy, housing recession, lackluster, employment growth and an inverted-yield curve should concern investors, particularly since the slowing economy likely will lead to a slowdown in corporate earnings.
Straszheim of Roth Capital
For the remainder of 2006 and the first few months of 2007, the Fed is on hold at 5.25%. The equity markets can handle a flat Fed Funds rate for some time. The 10-year Treasury is likely to remain in the 4.5% to 5% range during this period as well. The economy,either growth or inflation,would have to diverge from current readings in order for the Fed to react or for the 10-year to either rally or fall sharply. And as long as the economy traces a largely solid and sideways path, as we expect, there is no reason to expect this slightly negative yield curve to move materially.
Many market participants, indeed most, believe that the Fed will not allow inflation to get away on the upside. While a quarter century in the past, the memories of double-digit inflation remain alive. No one wants a repeat of that episode of double-digit inflation and interest rates.
Quinlan of Bank of America
We expect the fed funds rate to remain unchanged over the near term at 5.25%. We think interest rates (10-year Treasury) will hover in the 4.5% to 5% range over the next few quarters. A significant drop in energy prices could lead to even lower headline inflation and lower interest rates; the extent of the housing decline, and the overall impact on the U.S. economy will significantly influence interest rates over the near term.
