Equities: A Recent Pullback, Not A Change In Trend

OCEAN CITY — In our December Monthly Letter (Improving Growth, Low Inflation and Favorable Markets), we expected higher market volatility in 2014 driven by the reduction in monthly bond purchases by the Federal Reserve (Fed). What we had not expected was 38 days into the year, equity markets would have been hit by a range of Emerging Markets events, including political turmoil in Turkey and currency depreciation in Argentina.

Indeed, recent redemptions from emerging market equity and bond funds suggest fear here is rising. In addition concerns of an upcoming slowdown of growth in the developed world have risen following a softer set of economic data in the U.S. In our view, this soft data is likely to be temporary as a broader set of indicators provides a less negative outlook for the U.S.

Recent economic data in the U.S have called into question the strength of U.S. economic growth, and more broadly, global growth. Kicking off last week, the Institute of Supply Management’s Purchasing Manufacturing Index — a bellwether of the U.S. economy — fell to its lowest level since last May. Labor data for January too was disappointing, with last month’s nonfarm payroll additions coming in below expectations. This was the second consecutive month of weak employment growth. In our view, volatility over the near term is likely to remain elevated as investors weigh the recent soft data against the longer term more positive trend.

The recent disappointment in U.S. economic data has been concentrated on manufacturing parts of the labor market. We see a broader set of indicators remaining more favorable.

Among them is strength in the services side of the economy as spending remained healthy throughout the holiday season.

Importantly, one of the principal drivers of growth in 2014 – business investment – continues to show encouraging signs.

Data from the National Association of Home Builders and from companies show housing and corporate investment is still well underpinned.

More specifically, intentions of corporate capital expenditures looks promising. After disappointing for most of 2013, we have started to see an uptick in capital spending intentions. With the share of business

investment as a percentage of GDP at a low relative to the last two decades, the need for replacement spending is high.

In addition to the strong capital expenditures story in 2014, improving earnings data indicate corporate fundamentals remain healthy. Fourth-quarter earnings for the S&P 500 companies have so far come in above expectations. We don’t believe the recent stresses in Emerging Markets have deterred this trend. Bank of America Merrill Lynch (BofAML) Research Chief U.S. Equity Strategist Savita Subramanian notes in a recent report that approximately only 14% of S&P 500 sales are linked to Emerging Markets, suggesting large U.S companies are relatively insulated to Emerging Markets turbulence.

With a soft start to U.S. data so far in 2014, unsurprisingly, U.S. equity markets have fallen year-to-date. Putting the recent fall into context, pullbacks (defined as a loss of 5% or more) in U.S. equities are not that uncommon, as noted by Subramanian. She finds that pullbacks are fairly common and occur about three times each year. Corrections of 10% or more are far less frequent. We observe that markets have tended to recover from these corrections relatively quickly. As such, we believe this correction provides investors who are currently underweight equities an opportunity to rebalance to their strategic allocations.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)