Perspectives from Above the Noise – Week of October 27, 2014

The market rebound, which began with growing expectations that the Federal Reserve will maintain its zero-interest-rate policy into 2016 and the European Central Bank will expand its bond-buying program, received a boost last week from encouraging economic data. The risk that recent European weakness leads to slowing domestic growth remains an intermediate-term risk. However, the latest batch of data suggests the U.S. economy remains on firm footing in the near-term. As a result, U.S. stocks have rapidly recouped the majority of their losses for October through pockets of weakness.

Earnings results will also continue pouring in during the week and so far earnings season has been mixed. With around 15% of all companies reporting, 64.9% of firms have exceeded earnings-per-share estimates while only 49.3% have topped revenue estimates, according to data from Bespoke Investment Group. The less-than-stellar top-line results raise concerns about the quality of the earnings being reported. Broadly speaking, however, earnings results have been strong enough to soothe fears that weakness in Europe and a strengthening dollar would severely depress corporate results.

For the week, the S&P 500 rocketed +4.12%, the Dow Jones Industrial Average rose +2.59%, and the MSCI EAFE (developed international) gained +2.39%.

Here are the 3 stories this week that rose above the noise:
Today’s Deficit Is Not the Problem

The federal deficit for the 2014 fiscal year dropped to 2.8 percent of GDP, significantly below the 10 percent peak during the Great Recession. According to the Congressional Budget Office (CBO) projections, the federal deficit will remain below 3 percent of GDP through 2018. The CBO deficit forecast assumes that spending caps that were enacted in the Budget Control Act of 2011 will remain in place through 2021.

If the spending caps hold, Social Security, healthcare and debt interest payments will become a much larger percentage of overall government spending, which will reduce outlays on government programs that are investments in the future, mainly education, research and development, and infrastructure.

If the government spending caps do not hold and spending grows at the same pace as the overall economy without any tax increases or cuts in benefit programs, the federal deficit could increase ahead of baseline projections and reach 5 percent of GDP by 2021. As stated in the article, “today’s deficit is not the problem. Tomorrow’s looks bigger than the comforting projections suggest.”

The World’s Biggest Economic Problem

The Economist outlines the growing dangers of Eurozone deflation, which has played a major role in recent market volatility. The article takes the position that drastic actions are needed from the European Central Bank and political leaders in order to mitigate the risk of the region falling into a prolonged period of falling prices, similar to what Japan has experienced in the past two decades.

However, there does not seem to be much appetite for drastic action from either monetary or fiscal authorities and a true crisis may be required before an aggressive policy response is enacted. The article is sobering and pessimistic, but does a good job of presenting some of the risks in Europe that may continue to create market volatility for the foreseeable future.

Brazil Vote Highlights a Rift Linked to Economics

Brazilian voters re-elected Dilma Rousseff as president on Sunday, supporting a leader who has helped reduce poverty and kept unemployment low over a centrist challenger who criticized her government over a simmering bribery scandal and a sluggish economy. Rousseff took 51.64 percent, against 48.36 percent for her rival, Aécio Neves, the smallest margin of victory in any presidential election since democracy was re-established in the 1980s.

The election results highlighted widespread social and geographic divisions within the country. Rousseff won easily in the relatively poor northeast where recipients of social welfare programs broadly backed the incumbent, while Neves comfortably won in São Paulo, Brazil’s richest and most populous state. Brazil’s main stock index fell by 3.7 percent following the election, continuing a steep two-month decline which was largely attributable to the likely prospect of a Rousseff re-election.

Articles chosen and summarized by the First Allied Asset Management, Inc. investment management team.

International investing involves additional risk, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification.