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Health & Fitness

David Joy: Economic data takes center stage

So far this year, the pace of economic activity has been modest, while corporate revenue growth in the first quarter was flat and earnings growth was barely positive. Stock prices surged nevertheless, driven by a combination of multiple expansion and aggressive monetary stimulus by the Federal Reserve. More recently, however, investors have begun to question the future pace and duration of the Fed's quantitative easing program, and that has resulted in rising bond yields and a pullback in stock prices. As investors adjust to the idea that the Fed may be less aggressive going forward, the flow of economic data will become increasingly important, as it will not only determine how robust future earnings growth will be, but it will also influence the pace of any change in Fed policy.

The U.S. economy may accelerate somewhat during the second half of the year. The drag from fiscal policy will recede, consumer spending is expected to remain solid, supported by rising home values and gains in financial assets, and business spending is also likely to improve somewhat. At the same time, the Fed will remain quite accommodative, even if somewhat less so than at present. Under that scenario, earnings can grow and stock prices can resume their uptrend. After starting the year with a 1550 target on the S&P 500, I raised it to 1650 after the strong first quarter. While that target still seems reasonable, it is only a few percent above where we are today, and could prove to be too low. But stocks are now finding some resistance at the 50-day moving average of 1623, as investors try to balance their concerns about a potentially less accommodative Federal Reserve going forward, and expectations of modestly improving economic conditions in the second half. And the distinct possibility that a reduction in the pace of QE3 becomes a reality rather than just a threat, will likely temper the upside enthusiasm. It is also likely that the adjustment in bond prices is not complete. Although the yield on the ten-year Treasury note has risen almost 1% to 2.50 in just a matter of weeks, a further increase to the vicinity of 3.00% would not be unexpected, suggesting returns in the high grade bond market may struggle to be positive in the second half, and could exert some pressure on stocks in the process. On balance, return expectations favor stocks over bonds, and should be overweighted.

U.S. equities remain the most attractive, given the growth outlook, continued low inflation expectations, and reasonable valuations. The recent leadership rotation into more economically-sensitive sectors has a chance to be sustained. Consumer discretionary, financials, and technology appear to be the most attractive at the sector level. At the same time, the recent dramatic selloff in more defensive dividend-paying sectors, such as utilities, is starting to make these groups more attractive for those looking to generate income. Overseas markets are attractive in terms of valuations, but it is too early to conclude that the capital flight from emerging markets triggered by concerns about the Fed has run its course. Having said that, the correction in emerging markets has been sharp, with the MSCI EM index down 17% between May 9 and June 24. It must be noted, however, that the index has also rebounded by 6.5% in the four trading days since, as cheaper valuations have attracted some interest. In Europe, growth remains hard to come by, although Japan is meeting with some success in its efforts to jumpstart its economy, and after the recent correction Japanese stocks seem attractive.  

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Bond positions should remain somewhat defensive in terms of interest rate sensitivity. A further rise in yields toward the 3.00% level on the ten-year Treasury, from 2.50% at present, would not come as a surprise. Credit quality, however, remains generally healthy, creating better opportunities in corporate bonds and bank loans than in Treasurys. Municipal bond quality continues to improve, but their sensitivity to changes in interest rates and relative illiquidity suggests that portfolio positioning should remain in short to intermediate maturities here as well.

One wildcard for the global economy remains the pace of deceleration in China. The world's second-largest economy is attempting to engineer an orderly slowdown and avoid a credit bubble. In the process it has created some concern over funding in its banking system. It remains to be seen if they will succeed without a stumble.

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This week's report on June employment will set the tone for how investors will anticipate any change in Fed policy. The consensus expectation of 165,000 new non-farm jobs would seem to be a neutral number as far as Fed expectations are concerned. Something above 180,000 or below 150,000 might change that. However, it is uncertain whether investors will view unequivocally weaker or stronger data as good or bad, depending on its implications for a more or less active Fed. We are also close to the start of second quarter earnings season, which begins on July 8, and it is being approached with a sense of caution, given the lackluster economy and sluggish revenue growth. Until we have a better read on both, stocks may remain range-bound.

 

Disclosure

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

It is not possible to invest in an index.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services, Inc. Member FINRA and SIPC.

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