A Tale of Two Trends
Stocks in the U.S. tumbled last week, with the exception of a one-day rebound on Thursday. The Dow Jones Industrial Average fell 0.60% to 17,749, the S&P 500 Index dropped 0.87% to 2,053, and the Nasdaq Composite Index lost 1.14% to close at 4,871. Meanwhile, the yield on the 10-year Treasury fell from 2.25% to 2.12% as its price correspondingly rose. Equity markets continue to be driven by two interconnected trends: diverging monetary policy and a stronger dollar. The recent underperformance in U.S. equities is largely a function of these two dynamics, along with more expensive valuations. Some investors are reacting by focusing on domestic consumer stocks, and while this is a reasonable strategy, sluggish retail sales call into question whether or not the consumer will rebound as strongly as investors hope.Dollar Surge: Too Much of a Good Thing?
With the European Central Bank’s (ECB) quantitative easing program now in full swing and investors anticipating a greater likelihood of a June rate hike by the U.S. Federal Reserve (Fed), the dollar’s ascent is accelerating. (The ECB’s bond buying lowers yields in Europe, increasing demand for U.S. securities and thereby raising the value of the dollar versus the euro.) The Dollar Index is now at a 12-year high, up roughly 25% from last year’s lows. In contrast, U.S. stocks are essentially flat year-to-date. This is no coincidence.
While a cheaper currency is proving a boon for European and Japanese companies, the stronger dollar is creating a problem for U.S. exporters. The latest victim is Intel, which cut its current quarter revenue estimate by roughly $1 billion last week. A stronger dollar was cited as a contributing factor.
Adding to the challenge, the headwind on U.S. earnings is occurring at a time when U.S. valuations are expensive relative to other developed markets. The S&P 500 Index is trading at nearly three times book value, versus 1.67 for Europe and 1.75 for Japan. Without the tailwind of further multiple expansion—that is, investors paying more for each dollar of earnings, something that is harder to achieve with the Fed set to start raising interest rates—the market is left relying on earnings growth, where the rapid rise of the dollar is proving an impediment.
Consumers Forgetting to Spend?
Given the pressure on exporters and the recent strength in the labor market, it would seem reasonable to focus on companies selling to U.S. consumers. After all, not only are more jobs being created, but in this case, a stronger dollar is a benefit in that it extends purchasing power to U.S. consumers. Unfortunately, the reality is not matching the thesis.
In fact, retail sales are struggling, with February being the third consecutive month in which U.S. retail sales fell. Even after stripping out volatile factors—such as food, autos, gas and building materials—retail sales were still flat. Bad weather probably played a part, which helps explain why online sales were up over 2% as shoppers bought at the keyboard, but tepid income growth shares a large part of the blame. Nonetheless, with U.S. consumer discretionary companies outperforming the rest of the market year-to-date, this sector maybe vulnerable if sales do not start to accelerate, particularly as it now has the second-highest valuation (behind health care) of any of the 10 broadly recognized economic sectors.
We upgraded our view on U.S. consumer discretionary stocks last fall. We would still argue that households are in a better position than they were just a few years ago: Consumer debt is down while household wealth is up, gasoline prices are much lower than a year ago and the U.S. is creating jobs at the fastest pace since the 1990s. However, U.S. consumers are not yet playing to script. While household consumption was strong in the fourth quarter of 2014, it is off to a weak start in 2015. At the same time, consumer stocks have rallied on hopes for a spending rebound. If it does not materialize soon, it may once again be time to pull back from this sector.
