Last updated: 11:56 / Friday, 24 October 2014
J. Swanson, Chief Strategist

MFS Advice for the Next Couple of Months: Avoid the Market’s Black Diamonds

MFS Advice for the Next Couple of Months: Avoid the Market’s Black Diamonds
  • Weaker retail sales and manufacturing data have raised concerns about the cycle
  • Geopolitical sources of uncertainty suggest it might be time to take a step back
  • Based on the fundamentals, Mr. Swanson believes the US economy will ultimately prevail

James Swanson, Chief Investment Strategist at MFS, has been talking about a backdrop of improving fundamentals, particularly for the US business cycle. “We’ve seen unemployment claims falling and new job growth across a broad range of sectors, capital expenditures and the US export share rising, tax collections going up and the federal deficit shrinking, while consumer behavior has held steady”.

Last week we received new pieces of information that cast a cloud upon that relatively sunny outlook. In his latest commentary, posted in his blog “On The Lookout”, James Swanson comments on this data:

Warning shots

First, September retail sales were down across the board — even auto sales — without an explanation. Second, the Empire State Index for manufacturing in the New York region reversed dramatically, the latest evidence of weaker numbers from the production side of the US economy. I would say these are warning shots.

Yet the day after those reports, the four-week average of jobless insurance claims fell to levels not seen since June 2000, and industrial production surprised on the upside, driving capacity utilization toward 80%, which is considered “full capacity.” To cap the week, consumer sentiment rose to a new high. Let’s think about what’s going on.

One reason for falling retail sales could be a mini-cycle within the consumer sector, as we’ve seen before during this extended recovery. But with new workers being hired and some signs of higher wages, that seems a bit implausible to me. We cannot conclude from this one report that the US expansion is starting to decay.

Other concerns do knock on the door of the cycle, however. Europe is teetering on recession and China’s troubles continue to capture the headlines. Whether justified or not, fears about the Ebola virus outbreak could hurt business activity, especially now that several cases have been reported in Texas. And there are geopolitical worries, including the Islamic State militants moving into Baghdad and the sanctions against Russia likely taking a toll on the German economy.

On the bright side, earnings season has started, and so far the third-quarter reports have been coming in better than expected. Normally, in an environment with such positive fundamentals, I would focus on the ongoing trend of earnings growth.

Right now, however, we have other sources of uncertainty, and these might be more difficult to model. It may be time to take a step back.

Ski season

I’m a skier, so for investors with new money I’ll use an analogy that other skiers can appreciate. During this cycle, I believe we’ll get to the top of the mountain. We’re not there yet, but the symptoms of altitude sickness are already showing up. I’m beginning to notice the signs of vertigo — the dizziness, disorientation and uncertainty that many of us experience at such heights.

In this situation, I suggest that new skiers avoid going down the expert black diamond slopes, even the intermediate blues or reds. For the next month or two, until we get more information, stay on the greens where you feel comfortable, along with the other cruisers.

Ultimately, I believe the US business cycle will triumph because the overall fundamentals are still so powerful. Cash flows are rising and interest rates are falling. We now have a 10-year Treasury yield close to 2%. While this could be a signal of slower growth, it also means that the cost of capital is lower, which is a benefit.

Oil and gasoline prices continue to drop, another boon for consumers and producers, while the US dollar has been rising. Though this may turn out to be temporary, the evidence throughout recent history is that a stronger dollar has helped the US consumer by driving down energy costs and some commodity prices.

In the meantime, there are reasons for the latest spate of softness, and I think we have to take these concerns seriously.