David Joy: Some good news, some headwinds but still heading in the right direction

Last week’s better-than-expected employment report for the month of April put an abrupt halt to the negative sentiment regarding the pace of economic activity. Stocks surged more than 1.0% on Friday after the report showed a rebound in hiring from March, as well as significant upward revisions to the prior two months. While it contained some concerns, especially the decline in the length of the workweek, the jobs report was one of only a few recent economic reports that exceeded expectations. And, it was enough to suggest that the economy was not sliding into a serious second-quarter slump. Spending cuts from the sequester, combined with higher taxes, are creating headwinds for the economy, to be sure. And second quarter growth estimates are in the range of +/- 1.5%, a deceleration from the 2.5% pace of the first quarter. And many businesses have offered tempered guidance for the months immediately ahead in their first-quarter earnings reports. But the labor market report, in combination with an improving housing sector and still expanding manufacturing base, should be enough to keep the economy expanding at a moderate pace.

Not that equity markets seemed to take much notice of all the economic hand wringing. After slumping by just over 3.0% between April 11 and 18, on concerns about a weakened consumer sector domestically and slow growth in China, the S&P 500 has climbed almost 5.0%. Contributing to the solid sentiment has been earnings that have bettered expectations. But as we have pointed out in the past, this should not come as much of a surprise since expectations had been lowered so much. And it seemingly overlooks the fact that top-line revenue growth has been disappointing — cutting one’s way to prosperity works for only so long. Ultimately, it is the ongoing activism of central banks that seems to account for the refusal of stock markets to correct in any meaningful way, and on the contrary, to power their way to a series of new highs. As long as liquidity remains exceedingly abundant, the belief is that the markets have a floor under them that would be foolhardy to bet against. The Federal Reserve reiterated its own position last week, and in its meeting statement inserted the additional notion that the pace of quantitative easing could even be increased should activity warrant it, further reinforcing the idea of a market floor. The European Central Bank cut its main policy interest rate last week, and offered that it might even consider a negative interest rate on excess reserves in order to encourage lending and, presumably, to lower the currency. And, of course, Japan has engaged in a campaign of monetary shock-and-awe to jumpstart its economy out of its insidious deflation.

This monetary support and its attendant suppression of interest rates not only contribute to the favorable climate for equities in general, but to dividend payers in particular. Defensive sectors are leading the way higher for the year, and more recently so far for the second quarter as well. This demonstrates the desire for income, certainly. And it affords a way to acquire that dividend yield while making a less-than-full commitment to the case for equities, arguably somewhat stretched valuations for these defensive plays notwithstanding. But it also demonstrates widespread skepticism of the health of the global economy, as the laggard sectors include materials, technology, energy, and industrials. But that does not necessarily force one to conclude that equity market gains are illusory, as some have suggested. The U.S. economy, for one, has experienced real growth, albeit modest. Jobs are being created, housing is improving, and manufacturing is expanding. How much of this improvement would have taken place without the Fed’s support is debatable, but it is real nevertheless. Would equity markets be where they are if the real economy was not improving? Not likely. But equity markets, even those in locales where growth has been hard to come by, continue to at least want the ongoing support of the Fed and other central banks, and any hints to the contrary make markets nervous.

For cyclicals to assume market leadership, more tangible evidence of accelerating global growth will be required. This goes for commodities and bond yields as well. Until then, and as long as the data is at least decent, and the monetary spigots remain open, equity markets seem content in their belief that central banks have their backs.

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