Is the stock market right about economic growth?

Is the stock market right about economic growth?

High quality companies remain an attractive investment opportunity despite more moderate growth expectations.

"With the rising payouts we have seen, we believe that future dividend growth will more closely follow earnings growth"
Hersh Cohen

We prefer to have a strong conviction on stocks and the markets.  However, we view this environment as one of very conflicting factors.  Stocks are highly priced on an absolute basis, but are likely the best available asset class in a world where nothing seems inexpensive.  Because interest rates are still very low, investors remain reluctant either to sell stocks or buy more bonds.  Indeed, flows to equities have picked up this year.  The question on our minds:  is the rising stock market correct about profits and economic growth, or are low interest rates and falling oil prices better barometers?

Declining oil prices

The list of factors with current or potential impact on financial markets can be summed up in a short list. Once again, oil is near the top of the list.  Are declining oil prices a symptom of problems for the economy?  Instead of conforming to consensus expectations of rising prices, crude oil has again taken a downturn.  As we noted a year and a half ago, predicting the correct price for oil is elusive, as it is determined by supply and demand, as opposed to having some intrinsic value. While not yet as severe as 2015-2016, the current decline triggers fears of credit losses and diminished profits for oil-related industries.  Additionally, overall capital expenditures from manufacturing companies will fall.  Employment in oil-producing states will be hurt.  High yield bonds connected to exploration companies have been hit.  We have pointed out that in past years, we would cheer lower prices, as they would diminish the money flowing to OPEC.  Inflationary pressures would abate and consumers would have more discretionary income.  The shale revolution has altered the dynamics.  The U.S. is now the “swing” producer, creating large excess supplies. For the time being, the negatives seem to be outweighing the benefits.  Another job creation area has been clean energy – solar, wind, geothermal.  Sharply lower energy prices create fewer incentives for development and use of alternatives.

So why are consumers not showing the benefits of lower gasoline and heating costs?  Two things come to mind: higher health care costs and a step up in savings rates.  Consumers received a wake-up call from the recession and where possible, seem to have increased the percentage of income saved for the future. As we see the U.S. savings rate continue to tick higher, there is an impact on discretionary spending. One exception is in home improvement sales, where homeowners add value to their primary asset. Savings still have room to climb though as over half of Americans say they could not afford $500 in unexpected expenses. Although the number of people saving more has improved over the last seven years, it is still off a very low base.  Evidence points to one third of the country that has only enough to cover six months of expenses.  Years of stagnant wages for most workers has exacerbated the problem.

The second factor impacting markets is the string of problems from retailers.  Jobs are being lost as stores close.  E-commerce has given shoppers reasons to not travel to malls and other stores.  The impact is still being evaluated by the markets.  Commercial real estate is being impacted as stores go vacant.

Tax reform and tax cuts

Third, the markets are hanging on to the hope of tax reform and tax cuts.  In our opinion, the same thing that torpedoed many of President Obama’s programs is impacting the current administration.  The first thing both presidents did was attempt a huge overhaul of health care.  It seems apparent that success has been elusive and indeed current wrangling is likely to worsen the health insurance issue.  Furthermore, the antagonisms that have surfaced seem to us to make it unlikely that tax reform will be accomplished anytime soon.  There is still arguing going on about trade and whether tax cuts have to be offset with spending cuts.  The issue of a border tax is still being debated.  We remain skeptical of measures that would impact trade.  It seems to us that too many obstacles have been created to fulfill prior hopes for meaningful change.

We have a slow, tired and mixed economic recovery. Auto sales have peaked.  Fights over immigration are affecting the supply of labor in some industries.  The Federal Reserve is looking at low unemployment but seemingly ignoring signs of deflation.  Politics are divisive and at a near standstill.  But corporate earnings have been rising slowly. Millennials might soon decide to look at homes and continue the housing lift.  The weakness in the dollar is helping companies with large foreign revenues.  More than ample monetary liquidity has kept merger and acquisition activity at very high levels.  With real revenue increases hard to achieve in this low growth environment, more companies are exploring acquisitions or mergers to enhance earnings.

Dividend outlook

Our dividend growers continue to execute according to our expectations.  In an environment where income is hard to achieve, we remain constructive on the portfolios.  We do think dividend increases can continue, albeit at a slower pace. Dividend increases have surpassed earnings growth over the last several years, a trend that cannot continue indefinitely. With the rising payouts we have seen, we do believe that future dividend growth will more closely follow earnings growth, holding payout ratios more constant. And, as we did a year ago, we want to manage expectations for capital appreciation given the strong gains we have seen since the financial recession. Despite these more moderate growth expectations, we continue to feel good about the companies we own and believe that holding a portfolio of high-quality companies remains an attractive investment proposition in today's climate.



IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.