Much attention was focused last week on the August employment report in the US, which showed a better-than-expected loss of 216,000 jobs for the month, but also showed that the unemployment rate rose to 9.7%, its highest rate in 26 years.
Also in the news was evidence of an uptrend in corporate earnings estimates. For the month of August, 41% of revisions were to the upside, a noticeable improvement over the 14% figure for July and many months of less than 10% before that.
In the equity markets, stocks experienced another downturn, with the Dow Jones Industrial Average falling 1.1% to 9,441, the S&P 500 Index declining 1.2% to 1,016 and the Nasdaq Composite dropping 0.5% to 2,019.
In our opinion, the sloppy stock market behaviour over the last several weeks is more a result of a correction from overbought levels than a reflection of deteriorating fundamental factors.
State of the economy
Our current view of the state of the economy and the markets can be summed up by three broad conclusions.
First, the US and global recessions are in the process of ending, but the recovery will be much weaker than would normally be the case after such a steep downturn. Restrained credit conditions and the need for companies and individuals to rebuild their balance sheets will represent a major headwind to growth over the next several years.
Second, inflation risks should remain low for the next couple of years. At some point, it is possible that excessively easy monetary policy could lead to higher inflation, but we believe it is too soon to consider inflation a risk factor.
Third, from an equity markets perspective, we expect the combination of stimulative policy and a modest economic revival has and will continue to push stock prices higher.
‘Decisive upturn since March’
Regarding the economy, we have been seeing a decisive upturn in the Conference
Board’s Leading Economic Index series since March, a fact that has been reflected
by better financial market performance. This backdrop is consistent with an economic recovery, which we believe is in the process of beginning, and which we believe will be reflected by the third quarter GDP report.
There is widespread debate about the pace and durability of the economic recovery, and while we expect some positive news to continue, we do not believe this recovery will be robust.
The economic environment will likely continue to be a challenging one, and it will be quite some time before the economy is back on a solid foundation.
We understand the widespread concern expressed by many that Federal Reserve policy may cause higher inflation by staying too easy for too long, but we remain convinced that risk lies a few years away.
In our analysis, inflation pressures should remain dormant as long as there is so much slack in the labour and goods markets. As a result, we see no reason for the Fed to adjust its policy stance any time soon.
The market’s perspective
From an equity market’s perspective, there has been some question about how
attractive stocks are from a valuations point of view.
On the one hand, it would be reasonable to expect valuations to be below average, given the severity of the downturn and the high degree of uncertainty over the outlook.
On the other hand, however, extremely low levels of interest rates and inflation provide support in the other direction.
On balance, we believe that equities are fairly valued, and that earnings are likely to be the driver of market gains going forward.
From a long-term perspective, we think US stocks have the potential to deliver compound returns of somewhere around the 6% to 8% level over the next several years.
