The past month closed with dovish commentary from Fed officials, leading to a rally in many of the asset classes that declined ahead of a potential rate hike. Commodities and emerging markets experienced some of the largest gains in addition to gold, which broke its 200-day moving average and has traders looking for a test of the downtrend in place since 2011.
A Federal Reserve rate hike now appears less likely in 2015, and weakening domestic economic data is likely to be cited as the source of the delay. Economists were forecasting a growth rate above 3 percent at the start of the third quarter, with some even forecasting a 4 percent gain. An early trend of improvement was snapped in September and subsequent data has been mixed. Retail sales ex auto were down 0.3 percent in September, and job growth was slower than expected. There are only two weeks left before the government delivers its first estimate of GDP growth, and the Atlanta Federal Reserve’s GDP Now model predicts only 0.9 percent growth for the quarter.
Investors shouldn’t close the door on a potential rate hike just yet. Unemployment is low, while retail sales, wages and industrial production are at or near their highs. Most importantly, core inflation is running at a 1.9 percent annual rate, just 0.1 percent shy of the Federal Reserve’s 2 to 3 percent target. Headline inflation is only down this year due to falling energy prices, which have also weighed on transportation costs. Assuming oil doesn’t head back into the $30 range, year-on-year CPI comparisons will start to improve between November and January 2016 as oil prices are currently at January 2015 levels. The headline inflation rate could be running at nearly 2 percent or higher a year from now if oil prices simply stay put. Were energy prices to rally, inflation could quickly rise to levels the Federal Reserve would deem troublesome.
Earnings season recently began and has been a mixed bag thus far. General Electric (GE) and Bank of America (BAC) beat estimates, while Netflix (NFLX) and J.P. Morgan (JPM) disappointed investors. FactSet Research reports that the current forecast decline in earnings for the S&P 500 Index, including those companies that have already reported, is 4.6 percent. That is already substantially above the 5.5 percent decline forecast only a week ago, before major firms began reporting results. As we expected, the analysts were excessively pessimistic in their forecasts and it’s likely the decline will be much smaller, if not turn into a modest growth trend, by the time all the results are in.
The biggest surprise so far this earnings season has been Wal-Mart (WMT). The firm missed earnings and delivered negative guidance, blaming a rising U.S. dollar as well as wage hikes. In contrast, Amazon (AMZN) has seen its market capitalization surpass that of Wal-Mart. Amazon has been shifting away from its retail business and expanding its Internet services division, which relies on significantly fewer employees. This contrast in approaches may become more acute in the coming years if the move by Wal-Mart is the start of a trend, rather than a one-time disappointment by the retail giant.
Corporate profits have been high in recent years as a result of the suppression of wages due to globalization and high rates of immigration, which increased our domestic labor supply. Political forces on both the left and right are turning their focus to American workers now, with the left calling for a direct raise via the minimum wage and the right seeking to restrict the labor supply with tougher immigration laws. Wages and corporate profits have gone through long-term cyclical changes, and if another shift is underway, it could be one of the most important investment trends over the next decade.
Biotechnology is one sector delivering big productivity gains, though healthcare stocks took a beating over the past month. This drop followed Turing Pharmaceutical’s decision to raise the price of its antiparasitic drug, Daraprim, from $13.50 to $750 per pill. This led to comments by presidential candidate Hillary Clinton about high costs, which in turn sparked heavy selling in the volatile sector.
Investor concerns about political intervention are misplaced. Politicians have generally avoided doing anything to harm the drug and biotech industries, almost always “solving” the problem of high prices by increasing government funding. Politicians have also favored the sector: drug companies were major players in crafting the Affordable Care Act, for instance. Attacks on “predatory” pricing are a fairly common occurrence as they win points with voters, but we’ve seen little, if any, long-term impact on the sector. In 2014 Representative Harry Waxman sent a letter to the CEO of Gilead Sciences (GILD) questioning the high price of the hepatitis C drug Sovaldi. The treatment would cost over $80,000, but cured more than 90 percent of users. GILD stock plummeted on the news and took down the entire biotechnology sector with it, but six months later, the stock was back at a new all-time high.
The drop in healthcare stocks looks like a typical momentum sell-off. Momentum traders pile into winning sectors, leading to unsustainable outperformance. When momentum shifts, these short-term traders flee their positions, causing a rapid and unsustainable decline. These drops often provide excellent buying opportunities for long-term investors. It may be another month before we see shares move higher, but we continue to believe the outlook for healthcare is strong and that making a reactive change to our portfolio positions is not warranted. Having a bit of patience now will almost certainly reward investors over time.