Last updated: 10:56 / Thursday, 7 August 2014
MFS Strategist’s Corner

Linking Equities to the Economy

Linking Equities to the Economy

In this second of a series describing my tenets for long-term investing, I’ll review the connections between the US economy and the stock market.

Private sector focus

My next tenet is to focus on the investable part of the economy, which is the private sector, rather than the official GDP numbers. I think this is where a lot of investors have been getting it wrong. Ever since the US economy started to exit recession in mid-2009, the financial media have been full of stories about subpar growth of 2.25% on average — nothing like the more rapid pace of expansion in the V-shaped cycles during the 1980s or 1990s.

What’s behind this lackluster growth environment? One of the major components of GDP is government spending, and that has been shrinking for four years — culminating in the sequestration cuts to the federal budget at the beginning of 2013. State and local government expenditures have also been tightly constrained.

Meanwhile, the private sector has been growing at 3.3%, on average, over the past five years. This is a normal pace of growth, much like previous cycles. So looking at the private sector, this cycle has not been as unusual as the pundits would have us believe.

We came into this year with economists' mostly optimistic forecasts for growth in the developed world, with the United States set to finally achieve “escape velocity” or above-trend growth. The winding down of the sequester’s drag on fiscal spending was widely expected to be one of the contributing factors to stronger growth in 2014.

However, an extraordinarily cold winter in the US, along with other factors, called that into question. The latest reports have the US economy shrinking by 2.9% in the first quarter, almost like a mini-recession. Yet slow growth may not always mean that equities are doomed: S&P 500 revenues, profits and margins rose while GDP was falling.

Simply put, the companies that make up the US equity market benchmark have done quite well in this environment. As evidence suggests that the US economy has bounced back in the second quarter, I suspect that S&P 500 companies are likely to fare just as well — or even better. And that’s what matters for equity investors.

International profits

Another related tenet is to bear in mind that the S&P 500 does not look like GDP. We’ve watched this change rapidly over time, and now the equity benchmark is much more manufacturing oriented, much more tech heavy and much more international than the economy in general.

In the national income and product accounts (NIPAs) that describe the value and composition of output, the government tells us that the US no longer makes things. Manufacturing represents only 10% to 11% of the US economy, and technology a mere 5%. In the S&P 500, however, manufacturing and tech account for 48% and 18%, respectively. This is a huge difference.

Similarly, economists call the US a closed economy because just 11% of GDP is traded with other countries. By contrast, close to 40% of S&P profits come from international sources. So we have to pay attention to what’s happening outside the US. In fact, equity profitability despite the first quarter GDP contraction can be attributed in large part to the global nature of the S&P 500.

When we look at the four biggest export markets for the US — North American neighbors Canada and Mexico, along with the eurozone and China — nearly all fared reasonably well during the first quarter. Europe has shown signs of exiting recession in a mild but convincing growth pattern, and even China appears to be stabilizing. For now, the global recovery seems to be holding together, which I believe bodes well for US equities.

James Swanson, CFA
MFS Chief Investment Strategist