After a weak first quarter, it appears economic activity in the U.S. has picked up in 2Q 2015, though maybe not as much as initially thought. A weaker than expected retail sales report in June cast some doubt on consumption estimates, though May personal outlays showed the strongest consumer spending growth since August 2009. Housing data remains the biggest star of this quarter, as starts, permits and sales continue to climb, which all indicate the residential investment component of GDP will get a bump. Overall, despite a few remaining areas of weakness, we see the U.S. economy continuing to expand.
June's employment report showed the labor market continuing to tighten, while also highlighting the structural problems in the U.S. labor force. The unemployment rate fell to 5.3%, although this drop was due to a decline in labor force participation, rather than a bump in payrolls. That being said, payrolls still increased by 223,000, in line with the 3-month average. However, wage growth has yet to materialize, as average hourly earnings only rose 2.0% from a year earlier.
In the third week of 2Q2015 earnings season, the S&P 500 looks on track for earnings per share to fall 3.2% y/y. This is an improvement over the initial numbers and financials are leading the index after many of the big names reported strong earnings, followed by tech and healthcare after several significant surprises in earnings. As we get further in to earnings season, the dual macro headwinds of low oil prices and a strong U.S. dollar will come into play.
Headline consumer prices rose 0.3% between May and June (0.0% y/y), while core CPI inflation firmed slightly to 1.8% y/y. The headline month-to-month increase was driven higher by increasing energy prices, as the gasoline price index increased 3.4% m/m. Excluding volatile food and energy prices, core prices rose 0.2%, largely due to increases in medical care prices and owners' equivalent rent - a sign of the strengthening housing market.
The Fed remained on message when Chair Yellen testified before Congress. She continued to emphasize the data dependent nature of policy actions and that the Fed does expect to hike rates this year. Despite international volatility and a weak first quarter, the Fed is looking through the near term headlines. In the longer term, the Fed revised its projections for growth in 2016 and 2017 up at its June meeting, but showed dovishness in pulling its estimates of medium-term Federal funds rate downward, signaling a slow climb upward for rates. Even so, the initial hike is a round the corner as soon as the committee sees further improvement in the labor market and has "reasonable confidence" inflation will hit 2% in the medium term.
- Volatility caused by the timing and communication of Fed tightening.
- Political risk caused by a potential Greek default and/or exit from the single currency area.
- Deflation worries in other developed economies outside of the U.S.
- Volatility caused by sharp swings in commodity prices and exchange rates.
- A slow upward trend in earnings (despite the temporary drag from cheap oil and a high dollar), coupled with low interest rates, still make stocks look attractive in relative terms.
- Cyclical and small cap stocks are generally favored in a rising interest rate environment.
- High yield bonds look more attractive than Treasuries, but a diversified approach to fixed income investing seems appropriate given likely Fed tightening in 2015.
- Despite disappointing returns due to a stronger dollar in 2014, international exposure is still warranted given growth prospects abroad.