Enough Already : Investors Scale the Wall of Worry
July 16, 2012

Investors have been waking up in a cold sweat lately, as they ponder the impact on their portfolios of the ongoing Eurozone debt crisis, disappointing U.S. job growth and the apparent China slowdown. Couple this with contracting ISM readings and slowing EPS growth rates and many investors have come to expect more bad news and have chosen to sit on the sidelines. And while the market is likely to remain choppy for the next few months, the outlook isn't nearly as dire as many suggest.

The debate has heated up once again over the likely direction of markets with a mounting wall of worry that investors are trying to scale. The concerns are around the slowing Chinese economy and another flare up in the Eurozone sovereign debt crisis. Add in the disappointing U.S. job growth in the last few months and a sharp contraction in ISM and investors are anticipating a weak second quarter reporting period.

Despite the global turmoil, Chinese economic growth remains relatively unscathed. But unlike the West where Ben Bernanke has run out of bullets and in Europe where policy makers are dragging their heels, Chinese officials have both the room and the willingness to act. China 's modest debt-to-GDP ratio of 50% and lending rates above 5%, give it plenty of firepower to unleash if necessary. Already, China’s recent bout of monetary easing has seen credit flows picking up nicely, with loan issuance up 11% from May to June. China’s recent growth rate of 7.6% may have disappointed investors, but the country’s growth rate will still outpace that of most other nations over the next five years. In fact, the IMF expects China to grow, on average, at roughly 8.5% through 2014, compared with 6% for its emerging market peers and a sluggish 2.5% for developed nations.

Also weighing on sentiment is the S&P 500 second quarter earnings season, which hits its stride this week with 75 large caps set to report. With some of the biggest banks and information technology players reporting in the week ahead, this will be a widely followed earnings week. But already, index earnings growth rates are falling, with consensus estimates showing a decline of 2% on a year-over-year basis.

But much of the weaker second quarter numbers may already be priced into the market and worries that a weak Europe may impact domestic earnings appear to be overblown. There have been several periods throughout market history where the euro declined sharply, yet US corporate profits increased substantially. In fact there has been almost zero correlation between U.S. earnings growth and the direction of the EUR/USD over the past 30 years. S&P 500 companies generate roughly 60% of their revenues domestically, which provided a crisis in confidence is avoided, should not have a material impact on U.S. stock prices in the months ahead.

Sluggish job growth has been another persistent worry however companies remain in excellent fundamental shape and will ultimately begin hiring again when there is greater clarity on tax, health and other policies out of Washington. It may be early 2013 before larger corporate enterprises step up the hiring, but that isn't all that far away. The small business segment looks more promising, with hiring plans increasing lately, a very bullish signal for job seekers given that small business is primarily the engine of job creation.

The recent tumble in the ISM could be nothing more than a head fake, rather than the start of strong and consistent decline of the U.S. manufacturing sector. The true test of whether this decline becomes more pronounced will be in the next few months, when additional readings either confirm or buck this trend. But other indicators such as industrial production, exports and capacity utilization are showing a more robust trend for American manufacturing and quite possibly throwing cold water on the weak ISM numbers of late.

Investor sentiment remains overwhelmingly bearish and many have chosen to ride out the storm by parking their assets in cash, rather than risk it in the market. The uncertainty out of Europe will likely persist for some time, so markets will remain volatile. But while the market will move up and down in response to the various macro issues, I still believe that solid dividend paying franchises in the utility, pipeline, consumer staples, telecommunications and cable sectors remain the way for most investors to go.

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