David Joy: A few thoughts at quarter end

The economy is entering a new phase, where weather will no longer be the major headwind it has been for the past few months. Therefore, we will soon find out whether growth will accelerate toward a sustainable 3% or so pace, as many expect, or whether it remains stuck in a seemingly endless, less robust environment.

The spring housing season is going to be very important. Activity has plateaued in the past few months, and price increases in some markets have stalled. But theoretically, there is a significant amount of pent-up demand. According to the Atlanta Fed, the pace of household formation over the past five years collapsed by 60% compared to the pace of the previous five years. And while both prices and mortgage rates have risen somewhat, affordability remains high by historical standards.

Job creation also needs to move solidly above 200,000 per month, well above the 130,000 average of the past three months. Friday’s jobs report will be an important first test of these expectations. The consensus is looking for 200,000 new jobs, which would be good, but not great. Some private estimates are in the 225,000 range. That would likely be greeted warmly by equity investors. The length of the workweek will also be important, after a dip of 0.3 hours over the past three months that was blamed, of course, on the weather.

This week’s economic calendar also includes important releases on regional and national manufacturing activity, services, and auto sales, all important early indicators of the underlying pace of activity. Consumer spending needs to remain firm, and the long-anticipated capital spending cycle needs to gather some momentum.

The first quarter is in the books, and it was weak. Economic growth looks to have been in the range of 2.0% +/-. According to Factset, the quarter began with expectations that corporate earnings would grow in the vicinity of 4.5%. Those expectations now hover around 0.0, and could be negative.

Sales forecasts have been lowered to 2.6% from 3.2 at the start of the quarter. For all of 2014, earnings are still expected to grow by 8.7%. And while that is down from the 10.5 percent forecast of a few months ago, it implies double digit growth over the remaining three quarters of the year. Full year sales growth is now in the range of 3.4%, down from 4.0.

In order to get these totals, the economy needs to firm. And if stocks are expected to move higher from here, with valuations already somewhat elevated, earnings growth will have to deliver. Conversely, disappointment could result in some of the air coming out of equities. Alcoa kicks off reporting season after the close on April 8. To their credit, that U.S. equities managed to be essentially flat during the first quarter, as weak as it was, is something of a victory. It also speaks to the underlying presumption that growth is likely to firm as the weather improves, as will earnings.

Internally, there were some notable divergences within equities last week. As measured by the respective MSCI US indices, value rose 0.6% and growth fell 1.7%. Small caps sharply underperformed large, -2.8% in the S&P 600 versus -0.5 in the S&P 500. Biotech was weak was once again. The SPDR Biotech ETF plunged 10.1% last week, and has fallen 15.9% since Feb. 28. Banks were soft, with the SPDR KBE ETF down 2.8% in the wake of the Fed CCAR summary report on March 20 and the detailed report on March 26. Citigroup, in particular, lost 5.8% in the two days following the release of the report, after its capital plan was rejected for qualitative reasons.

Lastly, I don’t subscribe to the view that Janet Yellen’s “six month” comment, in regard to when the first interest rate hike could occur following the end of QE, was a so-called rookie mistake. Rather, I think it was an honest, reasonable assessment of when we could see the first rate hike if the data is strong enough. Calling it a rookie mistake is an excuse for those who were positioned incorrectly for the market reaction. What the Fed ultimately does is fully dependent upon the data. Those who were too complacent about that have been put on notice.

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