Permanent Value

Week in Review (4/17/14)

Bruce Doole
April 17th, 2014

U.S. Economic Outlook Lifted by Favorable Tailwinds (Part II)

Housing Rebound Firmly in Place

With the job market improving, new household formation is on the rise. Consequently, the demand for housing is greater and, with inventories limited, prices are moving higher. During the past two years, home prices have appreciated at a rate of about 10% a year. Rising home prices help cure a lot of ills in the economy. They help homeowners get out from being “underwater” on their mortgages; they help increase the geographic mobility of the labor force; and they lead to rising wealth among homeowners. In addition, they help improve banks’ balance sheets, allowing them to loosen lending standards and begin making home loans again. All of these factors, in turn, are fueling a recovery in residential construction.

Europe Goes from Bleak to Better

U.S. export growth over the past two years has been moderate to disappointing, largely because of the recession in Europe. With the euro zone emerging from recession in mid-2013, U.S. exports have perked up — especially as the euro has strengthened against the dollar, making U.S. exports more attractive. To be sure, economic growth in the 18-member euro zone remains lackluster at best. But, like the U.S. economy, the trend is positive, and the potential for faster growth is there. Taken at face value, the Institute for Supply Management’s Export Orders Index suggests the potential for a significant acceleration in export growth later in the year. This would provide a tailwind to U.S. economic activity that was largely absent in 2012 and 2013. Moreover, the ongoing recovery in Europe should also provide a boost to China, a significant exporter to Europe, resulting in a brighter outlook for the global economy overall.

Outlook for U.S. Equities

The U.S. equity market has reached record highs in recent months, as measured by the Standard & Poor’s 500 Composite Index, and the price-to-earnings (P/E) ratio has expanded. While the current P/E on the S&P 500 might seem high relative to past periods when bond yields have been between 2.5% and 3%, it is important to note that bond yields right now are artificially low, in part because of the Federal Reserve’s massive bond-buying program. In a more normal environment, bond yields might be between 3.7% and 4.7%. Historically, when bond yields have been in that range, the average valuation of the U.S. equity market has been very close to what it is today. In addition, if the U.S. economy accelerates by 1% in 2014, history suggests this could generate 10% to 12% earnings growth. So if valuations hold up, 2014 could still be a decent year for U.S. equity returns.

This Week’s Economic Data

-FOMC Minutes reveal that most FOMC participants saw a pickup in GDP growth after first quarter bad weather.
-Import and Export Prices are both trending slightly upward. Import prices rose 0.3% excluding fuels, while export prices rose 0.8% for the month.
-Jobless claims fell by 32,000 to 300,000 for the week of April 5, the largest drop in more than 10 years.
-Producer Price Index dipped 0.1% in February, after rising 0.2% in January.

Sources: Capital Group/ Ivy Funds