The summary version of our view is that we see the S&P 500 ending 2012 at 1,400 with a mid-2012 dip to 1,200 followed by 1,600 around 2013-14 on a P/E 16x normalized, albeit sharply slowing EPS. By mid-2012, we anticipate QE3 in response to deflationary shocks. Beyond mid-2012, we expect large cap growth equities to lead the S&P 500 higher with financials fueling (and capping) the S&P rally at 1,600. The S&P benefits from a U.S. head start rebalancing which we believe is three years ahead of the Eurozone (which is in the lender of last resort stage) and 4 years ahead of China (in the post policy tightening aftermath stage). Additional benefit to the S&P may arrive in the form of foreign equity inflows by mid-decade as the EM and EU painfully rebalance.
Markets are operating in a backdrop of a fragile and policy-supported U.S. economic recovery with continuing concern about global economic slowdown - primarily in China and Europe - and geo-political hotspots where East and West meet, which is the Middle (East). We forecast U.S. GDP growth experiencing a lull in mid-2012. Our view is that U.S. consumers will respond negatively to energy inflation and lagging wages by 2Q12, causing an inventory adjustment on the heels of slowing fixed investment (corporate capex, construction) following the expiring 2011 investment tax breaks but before rising unit labor costs and inexpensive capital work their magic to stimulate capital-for-labor substitution via fixed investment in 2Q12.
We forecast U.S. real GDP 2012 to 2015 of 3% +/-0.5%, and adding 1-3% inflation that equals a nominal GDP growth rate of 4%-6%. While some worry about inflation, our eye is on where the "hockey puck may be going," which seems to us to be deflation risks. Our concern about the effect of deflation on nominal GDP is illustrated by this example: if real GDP of 3% is met by (3)% deflation, then even 1% interest long-term interest rates will prove insurmountable for a 0% nominal growth economy (3% real GDP plus minus 3% deflation). Since de-leveraging is by definition deflationary because it reduces the quantity of money, thereby making money more valuable versus things (e.g., price deflation), is deflation unavoidable?
To answer the question of the outlook for deflation we turn to the U.S. fiscal and monetary response. In effect, the U.S. is swapping private debt for public debt, lowering the cost of debt via this refinancing. Household debt as a percentage of GDP has been falling, albeit largely from defaults, while corporate net debt has been falling because of the rise of cash balances fostered by rate and currency policies that lift margins. In cooperation, the U.S. Fed has suppressed interest rates in response to the deflationary shock waves (i.e., dollar strength). We expect more shocks to emanate from the disarray overseas, inviting Quantitative Easing (QE, or Fed asset purchases and market intervention via newly created money) version 3.0 by mid-2012. We believe that we have consistently been more bullish on central bank actions than consensus, viewing central banks as “the new bubble,” creating coat-tails for investors to ride.
This is not to say we are unaware of the mid-decade risk associated with a difficult central bank exit from 0% U.S. rates, 1% liquidity loans by the European Central Bank (ECB), and massive issuance of sterilization bills by the People's Bank of China (PBoC). The large balance sheets of the central banks create a “carry trade” via their low cost of funds and their highly leveraged portfolios. The central banks are essentially hedge funds that may go upside down when rates rise. Since rising rates embody GDP “traction” concurrent with de-leveraging in whatever troubled sector exists in the respective regions, we believe monetary policy presents mostly tail risk via the “success” outcome.
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Primarily for that reason, although we see the S&P 500 around 1,600 by 2013/14, we see the index back to 1,200 by 2015, capping a 17 year flat period (1998 to 2015E) around 1,200 which is truly a large capitalization equity secular bear market worthy of predecessors in 1907-1921, 1929-1942 and 1968-1982. By mid-decade, we see reserves created by repeated QE as having diminished Fed rate setting power, which may force the Fed to utilize the central bank's balance sheet to manage policy, a form of Keynesian (fiscal deficits) to monetarist (Fed) hand-off about which we are somewhat optimistic given U.S. reserve currency status and attendant low borrowing costs. Our long-held view is that reserve currency status isn't at risk so much as reserves - which are a consequence of imbalances - are at risk of dissipating steadily for the next generation. In our mind the era of unbalanced growth has ended.
Though U.S. investing is tumultuous, we believe overseas is a minefield. We view Europe as being in the “lender of last resort stage,” similar to where the U.S. found itself three full years ago in 1Q09 (TARP, Lehman, etc.). European Central Bank (ECB) 1% loans for three years are simply bridge loans to facilitate the recapitalization of European banks, in our view, which can occur with de-leveraging via credit contraction or equity raises, so the ECB climb down from a balance sheet that is now larger than the U.S. Fed may take more than one "three year loan" cycle roll-over. This is hardly a prescription for euro currency strength, in our view. Eurozone politics, while having made some marginal progress, continue to be bogged down in bickering and indecisiveness. We believe a eurozone “plan” is imminent, supported by Germany due to their weak position as an over-extended creditor. Simply put, we think Germany is holding out for the best deflationary fiscal discipline it can extract from Europe’s periphery before acquiescing to a long-term work-out and implicit backing for a mildly reflationary money policy (0% wage growth before productivity gains in the periphery + France, and 3% German wage growth with more consumption). Germany is arduously learning that kernel of country wisdom that “If you wrestle with a pig, you get dirty and the pig just enjoys himself.” With far more to lose by "getting dirty" wrestling with the EU periphery for a deflationary outcome, as evidenced by Spain's unilateral increase in its deficit target, we think Germany will eventually bend. As is often the case with difficult decisions, we feel that the forthcoming deal may ultimately prove less onerous than Germany and the ECB currently expect due to forthcoming peripheral European productivity gains which we attribute to a rising middle age to young worker ratio in that region, a view we believe to be quite non-consensus.
Also on the international front, China is seeing the beginning of a slowdown in GDP growth and is in the stage we call "the aftermath of a tightening cycle," the state of wary denial in which the U.S. found itself four years ago in 1Q08 when we and the Fed were aware of the looming housing crisis but dismissive of the extent of its effects. China faces the challenging transition of peaking savings and fixed investment with rising income and consumption, a normal stage of national development crossed by Japan in 1974, Taiwan in 1988 and South Korea in 1990. Those smaller, more urban countries are comparable in many ways to coastal China, and there are repeated historical precedents for prosperity taking hold much more quickly on the coast and slowly in the hinterlands. This period for China features a mismatch between the decline in growth of exports and fixed investment that out-paces the ability of less cyclical consumption to fill the void. With over-capacity after years of excessive capital spending, we expect China to wrestle with trade tensions and negative “operating leverage” (profits falling at a faster rate than sales) due to margin pressure in China.
With corporate savings (retained earnings) the largest pool of domestic savings, we expect fixed investment to suffer (Savings = Investment) in the largely closed Chinese system. This will place restrictions on future Chinese GDP growth, resulting in a more sustainable ~5%/ year rate by 2021 (quite possibly a non-linear deceleration suggestive of recessions) versus 9.2% real GDP growth in 2011. With slowing Chinese GDP growth, we anticipate a choppy and shrinking rate of growth (i.e., growth, but at a slower rate) for the consumption of commodities such as petroleum and copper. With commodity equities it is all about the rate of change in the rate of growth, the “second derivative,” so our view is that the "China story" for the related commodity stocks is over this quarter, and we expect valuation multiple compression to offset strong earnings from this point forward. With China's eroding trade surplus cheaper oil is more of an imperative, so they may help broker a solution in Iran that we feel would remove $20/bbl. from Brent crude. In addition, since the ability to fix currencies and create massive surpluses that lead to global imbalances is also over, in our view, we expect the living standards of other less top-down Emerging Market (EM) economies to improve at a slower pace in terms of commodity consumption per capita, thereby allowing for a better commodity supply/demand balance in the coming decades.
With respect to the international economy, the transitory nature of company earnings derived from weak dollar policies have largely been ignored by the S&P 500 for which a low price-to-earnings (P/E) ratio appears to put little credence in EPS derived from foreign strength and labor suppression. Besides translation gains, we believe having a weak U.S. dollar since 2002 has enabled corporations to use their lack of pricing power as a "club" to control labor costs by creating the practical ability to move production around a world without concern for currency or expropriation losses. This blissful strengthening of the "rule of law" in the EM was nursed by economic growth, but history suggests it may quickly turn negative when growth slows, a painful lesson we expect some multi-national corporations to re-learn in the coming years. Even as foreign-sourced earnings come under pressure, however, we believe S&P 500 downside seems limited to ~1,200 by second half 2012 because of the "protection" afforded by a low market P/E ratio. Interestingly, prospects for even greater woes seem clustered in the “BRICS” (Brazil, Russia, India, China, South Africa) market darlings, which we bemusedly note was a made-up Goldman Sachs acronym that became a Summit Meeting. If the U.S. trade deficit narrows and the Fed hikes rates from less than 10 basis points (bps) to 100bps or 1% (a 10-fold increase) by mid-decade, we would expect a de facto dollar shortage to develop, which in turn would likely damage commodity exporting economies that form the B, R and S in BRICS as well as many of the OPEC oil producers. A shortfall in revenue for those governments may prove difficult in terms of budget balances, revealing the weaknesses of crony capitalism and top-down political authority in those states. After some strife, which we would only expect to strengthen equity inflows to the U.S., we see the backdrop for a pro-cyclical dollar (a dollar that rises with growth and not lack thereof) and P/E expansion for "growth" stocks. This disarray in the EM may also further the century long shift toward secular, capitalist, democracy that has been underwritten by an elastic U.S. currency.
In the U.S. political sphere we anticipate President Obama’s re-election opposite a Republican controlled House and a closely split Senate, the latter serving as the pivot of "reason" standing between demagoguery emanating from the House of Representatives and White House. This likely perpetuates the gridlock and 11th hour deals experienced the past three and a half years. In a sense, however, this may be the best outcome for markets, because it leaves the market free to reach a clearing price for leveraged assets (notwithstanding Fed efforts and occasional interference), thereby allowing the write-off of worthless positions. Since the old rule of thumb is that "a turn-around takes seven years," borne out of our repeated analytical experience, we expect the Panic of 2008 to be followed by some fireworks ~2015. From a taxation perspective, a sudden 2013 post-election tax hike may tip the U.S. back into recession, so a longer-term phased-in approach is our expectation as the bond market enforces both spending cuts and tax hikes by mid-decade. In terms of long-term fiscal policy changes, our view has been that the end of the Cold War ~1992 created a surplus of global savings as Asia partially shook off socialism, thereby unleashing pent-up productivity and creating excess savings that fostered Western debt while putting the Bond Market Vigilantes to sleep. That interest rates remained low despite rising demand for debt, and also given that innumerable creditors have stood in line to fill the void after periodic bankruptcies (example, Argentina 2002) is evidence that this was an excess savings "supply-side" issue. With reduced growth in the pool of global savings due to the very global rebalancing we believe the Fed initiated via QE, we see bond markets becoming less forgiving of government profligacy in the second half of this decade. So, following the monetary gyrations of central bank exit mid-decade, we see a period of difficult fiscal adjustment in the second half of this decade, with the U.S. equity market offering powerful trading opportunities throughout the period.
Source: Stifel Nicolaus, Market Strategy, March 12, 2012.
Important Disclosures and Certifications
I, Barry B. Bannister, certify that the views expressed in this research report accurately reflect my personal views about the subject securities or issuers; and I, Barry B. Bannister, certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this research report. For our European Conflicts Management Policy go to the research page at www.stifel.com.
Stifel, Nicolaus & Company, Inc.'s research analysts receive compensation that is based upon (among other factors) Stifel Nicolaus' overall investment banking revenues.
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BUY -For U.S. securities we expect the stock to outperform the S&P 500 by more than 10% over the next 12 months. For Canadian securities we expect the stock to outperform the S&P/TSX Composite Index by more than 10% over the next 12 months. For other non-U.S. securities we expect the stock to outperform the MSCI World Index by more than 10% over the next 12 months. For yield-sensitive securities, we expect a total return in excess of 12% over the next 12 months for U.S. securities as compared to the S&P 500, for Canadian securities as compared to the S&P/TSX Composite Index, and for other non-U.S. securities as compared to the MSCI World Index.
HOLD -For U.S. securities we expect the stock to perform within 10% (plus or minus) of the S&P 500 over the next 12 months. For Canadian securities we expect the stock to perform within 10% (plus or minus) of the S&P/TSX Composite Index. For other non-U.S. securities we expect the stock to perform within 10% (plus or minus) of the MSCI World Index. A Hold rating is also used for yield-sensitive securities where we are comfortable with the safety of the dividend, but believe that upside in the share price is limited.
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