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U.S. economic growth already notched higher last year toward 3%. This year, with a stronger and retrofitted consumer,
a working credit creation process, better capital spending,
and improved results from both lower energy prices and
lower bond yields, expect real GDP growth to accelerate to
between 3.5% and 4%.
As shown by Chart 9, China is likewise stimulating its economy with lower bond yields. Its currency also experienced a
mild but rare decline last year against the U.S. dollar which
should help stimulate Chinese growth. While we do not
expect much acceleration in emerging world growth this
year, we do think the trend of slowing economic growth in
the region will end in 2015. If a consensus simply perceives
that emerging world growth has finally bottomed, it would
significantly improve the outlook for the global economy.
Chart 9: Chinese 10-year government bond yield
Deflation to reflation?
Most expect the U.S. dollar to continue rising this year. The
Fed will likely begin raising interest rates soon while sluggish
growth abroad should keep policy officials there in accommodation mode. However, it is not the different monetary policy
actions which matter most for the currency. Rather, it is how
those actions are perceived. If the more aggressive policies in
the eurozone and Japan work and boost economic growth, it
should bring a bid to both the euro and the yen. Conversely,
if the Fed begins raising interest rates but only after most investors believe they are behind the curve, worsening inflation
anxieties would reduce the value of the U.S. dollar. We expect
the pace of economic growth to improve across the globe
this year. In many weaker international economies, this will be
met with relief and a partial revival in currency values which
were widely priced for recessions or worse. However, since
the U.S. is nearing full employment while growing at one of its
strongest paces of the recovery, good news on Main Street
may become bad news on Wall Street. That is, if inflation/
overheat/Fed behind the curve fears escalate, the U.S. dollar is
likely to retrace some of its recent gains.
Moreover, as illustrated in Chart 13, developed world currencies have remained in a broad range for several years. For
example, the euro/dollar exchange rate has remained largely
within a range between about 1.2 to 1.45 for the last decade.
Developed economies all suffer from a similar fateaging
demographics which have slowed potential economic growth.
Because economic growth is so scarce, no developed country
is allowing another to steal precious growth through cheap
devaluations. In our view, competition for growth among
developed economies has caused exchange rates to be unofficially tied together within broad trading ranges. Currently, the
U.S. dollar is near the upper end of these multi-year trading
ranges against most developed country currencies including
both Japan and the eurozone. As shown in Chart 13, if the
widely feared imminent breakup of the eurozone union in
2012 could not force the euro-dollar exchange rate out of
its prolonged trading range, we doubt it will fall much lower
against the dollar today.
In addition to the potential conflict this year between improved economic growth and potential inflation fears, the
stock market also shows three significant vulnerabilities.
First, as illustrated in Chart 17, investor sentiment is currently calmer and more confident about the future than it has
probably been at any point in this recovery. The foundation of
the current bull market since the great 2008 crisis has been
climbing a perpetual wall of worry. The common characteristic of this recoveryfearseems to be absent as we
begin 2015. Three years of solid gains in the stock market and
much better conditions on Main Street have dulled investor
appreciation for risks. Often the stock market delivers a nasty
reminder about risk just when most investors start to believe
the water looks safe again.
Chart 17: AAII U.S. Investor Sentiment Index
Percent bulls less percent bears
We think the U.S. may be in the middle of the longest economic recovery in its history. If this is accurate, notwithstanding perhaps a more difficult 2015, the current bull market
probably is far from over.
The U.S. economic recovery is five and one-half years old and
is already longer than a normal recovery. However, for two
primary reasons, we expect it will last several more years.
First, during the last three decades, recoveries have lengthened compared to historic norms. The U.S. experienced an
eight-year recovery in the 1980s, a 10-year recovery in the
1990s, and a six-year recovery in the 2000s. Aging U.S. demographics caused the growth rate in the working age population to slow nearly by one-half since 1985. Since the labor
supply has grown far slower, the overall pace of U.S. economic
growth has also been noticeably weaker. The silver lining of
slower growing recoveries, however, is they tend to persist.
It takes longer to tighten resource markets, create inflation
or interest rate pressures, and produce the excessive private
sector behaviors which ultimately make the economy vulnerable again to a recession. While the contemporary recovery is
in its sixth year, it is younger than the average recovery during
the last 30 years!
Second, recessions often result from overconfidence among
private sector players, investors, and policy officials. Typically
in recoveries, confidence eventually mutates toward cockiness. Businesses over-expand, consumers over-leverage, banks
over-lend and the Fed over-tightens. These are precisely the
behaviors which bring the next recession. Today, due to the
severe psychological damage done by the great 2008 crisis,
There have been only two other times in post-war history when the stock market finally reached trendline again
after languishing far below average for several years. The
1950s-1960s bull market reached trendline in the mid-1950s
and the 1980s-1990s bull market reached trendline in the
early 1990s. Both of these previous bull markets rose nearly
as much after reaching trendline than they did recovering to
trendline. Consequently, since todays stock market seems
similarly positioned (i.e., it has just returned to average), provided the economic recovery is not prematurely aborted by a
near-term recession, this bull market could last considerably
longer and rise significantly more.
A little math illustrates the potential for stocks should the
current economic recovery last several more years. Trailing
earnings per share for the S&P 500 should be close to $120
as of year-end 2014. Assume the economic recovery continues for another five years and earnings grow only modestly at
about 4% annually. Perhaps annual nominal GDP growth is 5%
to 6% so this assumes some profit margin erosion. However, this would put trailing 12-month share earnings at about
$145 for the S&P 500 in five years. If the P/E multiple reaches
previous post-war bull market peaks in the low 20 times
earnings, the overall S&P 500 could surpass the 3000 level!
With dividends, this would represent about 10% buy and hold
annual returns during the next five years.
As this example shows, although 2015 may prove more
challenging for the stock market, investors should not get
too defensive since its long-term potential remains favorable.
Nobody will remember if you avoided a 10% to 15% correction in 2015 if you are incorrectly positioned for the next
50% advance!
Summary
Even if the stock market does indeed prove flattish this year,
the financial markets could still have a very successful year
in refreshing the bull market. If earnings rise again this year
while the stock market trends sideways, the P/E multiple may
be back closer to average again as we enter 2016. Moreover,
by year-end, interest rates may be at more appropriate levels
which would reduce future inflationary concerns and improve
the longevity of the recovery. Furthermore, if the stock market does suffer a correction this year, investor sentiment may
again be much more conducive to an ongoing bull market (i.e.,
appropriately conservative with ample buying power on re-
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Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2015 Wells Capital Management