The US stock market rallied in the third quarter of 2012, following a decline in the second. US stocks, as represented by the S&P 500 stock index, advanced 5.8% to 1441, in response to strong policy action by the European Central Bank and the US Federal Reserve. The yield on the benchmark ten-year Treasury note fell modestly to 1.64% from 1.66%, while gold and oil rallied in sympathy with stocks and a potentially more inflationary environment as a result of central bank action. Gold climbed 10.8% to $1,772 per ounce, and US benchmark West Texas Intermediate oil rose 8.2% to $92 per barrel.
The major driver of markets in the third quarter was strong action by the world’s two largest central banks, the US Federal Reserve and the European Central Bank (ECB). In response to duress in the markets for Spanish and Italian government bonds that could potentially lead to disintegration of the Euro currency zone, ECB President Mario Draghi said that he would do “whatever it takes” to maintain the integrity of the Euro. He followed up his words with action, committing the ECB to buy an unlimited amount of a country’s short-term debt if it first agreed to the terms of a bailout with the Euro zone’s political leaders. Markets responded positively to this action, as it relieved the immediate threat of a further deterioration in the ongoing European financial crisis. Longer-term, however, it remains to be seen whether or not European politicians can take the steps necessary to put the Euro on a sustainable path, including a more centralized fiscal system and bank supervision. These are extremely high hurdles politically. We fully expect more potentially destabilizing developments out of Europe in the future, as recent street protests in Spain and Greece demonstrate.
Following on the heels of the ECB action, the US Federal Reserve announced that it would purchase $40 billion of mortgage bonds per month indefinitely until the US employment significantly improves. This action is popularly known as QE3. (QE is short for quantitative easing, which is the technical term for central bank bond buying with freshly printed currency. This is the third installment from the Fed, ergo QE3.) While many Wall Street economists and strategists responded skeptically to this action, the stock market itself rallied strongly both in an anticipation of and in response to the Fed’s aggressive new policy. Gold rose to its highest level since February as investors looked to protect themselves against potential inflationary effects. Our opinion is that this is constructive policy. By reducing the amount of investable assets in circulation, the Federal Reserve drives up the value of the remaining assets, most notably stocks and real estate. When their assets appreciate, consumers feel wealthier and are more likely to spend, thus advancing economic growth and employment. As far as any inflationary impact goes, we believe it will be muted in the near term given the huge amount of slack in the system with unemployment over 8%, i.e. inflation is typically driven by tight labor markets, which is far from the case today.
Turning to the underlying economy and corporate fundamentals, the US economy continues to grind forward slowly but steadily. Economic growth is clocking in at around 1.5%, which is too slow to appreciably reduce the unemployment rate. Globally, the international economy is also struggling. Emerging markets such as China, India, and Brazil are slowing, while much of Europe is mired in recession. Given the tepid economic backdrop, the outlook for corporate profits has moderated. However, in the five years since the global financial crisis began, US companies have reduced operating costs significantly, and profit margins are near all-time highs. With interest rates at record lows as well, companies can borrow at extremely generous rates, thus minimizing interest expense and strengthening their balance sheets. As long as the economy can avoid moving back into recession, which we think likely, we do not see a significant deterioration in corporate profits.
We are sanguine on the economic outlook because the aforementioned Federal Reserve action and nascent strength in two pillars of the US economy, housing and autos. After six years of declines, the US housing market seems to have finally turned around. Sales are up, prices are up, and construction is up, albeit from very depressed levels. In addition to making consumers feel better about their personal finances, as we previously discussed, increased housing wealth and construction activity also stimulate the economy directly through employment in the real estate brokerage, construction, and home improvement industries. The market for automobiles has shown similar strength. After years of depressed sales due to the financial crisis, hitherto suppressed demand is finally emerging as people are gaining enough confidence to go out and make a major purchase, while at the same time auto loan credit is becoming more widely available. The automobile industry is significant in that it touches almost every sector of the national economy, from basic materials, to transportation, to electronics, to manufacturing, to financing, to dealerships. In short, a strong automobile industry can serve as a backstop to the overall economy.
The single biggest threat to our moderately positive outlook is the so called “fiscal cliff” that may be triggered at the end of the year if US politicians cannot come to an agreement to avoid tax hikes and spending cuts equivalent to 4% of GDP. This would very likely cause a US recession if it were to come to pass. Because the impact on the American people would be so disastrous, we believe that the crisis will ultimately be averted, but are also confident that there will be significant political drama in getting to a deal. From a market perspective, we think this political drama will drive a pickup in market volatility following the election, when the fiscal cliff comes firmly into focus. That having been said, we think the long-term impact will be minimal because we think it is probable that a deal will be cut before any lasting damage is done, i.e. either this year or early next year. One caveat is the likely expiration of the 2% payroll tax cut. This will take $1,000 out of the hands of the average American household and negatively impact already fragile consumer demand. For the remainder of the year our forecast range for the S&P 500 is 1350 to 1525. It closed the third quarter at 1441.
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