January was a rough month for equity markets. Volatility increased and stocks endured some notable setbacks. For the month, the S&P 500 Index fell 3.0% after declining 2.8% last week. We believe, however, that the same factors pushing stock prices lower will actually support longer-term economic growth. We expect markets will stabilize and recover in the coming months, and that by the end of 2015, equity prices will be at a higher level than where they began the year.
WHAT'S BEHIND THE DOWNTURN
One of the main culprits driving markets lower has been the precipitous drop in oil prices. To be sure, the fall in oil prices does have some negative effects as it hurts energy producers and related industries, resulting in a near-term drop in earnings expectations. This has translated into falling equity prices.
It is important to remember, however, that the negative consequences occur sooner than the positive effects. There are far more users of oil than there are producers, and lower energy prices clearly benefit consumers. Since the consumer sector accounts for 68% of U.S. gross domestic product, we expect these positive effects will filter through the economy over time. In fact, we are already seeing this to some extent. While fourth quarter GDP growth was slightly below expectations, consumer spending jumped to 4.3%, its fastest pace since the beginning of 2006.
Similarly, earnings and equity prices have been hurt by the stronger U.S. dollar. A stronger dollar puts pressure on U.S. exports and has been another cause of lower earnings expectations (and hence equity prices). Longer term, strength in the dollar is good news for the economy, but short-term pressure on earnings and equities can make it tough to remember this.
WHY EXPECT A TURNAROUND?
Since the end of the Great Recession, equity markets have soared ahead of a lagging economy. For years, we have been more confident about the direction of the equity market than we were about the direction of the economy. But that is no longer the case. Now we believe the economy will lead the equity markets.
We believe U.S. GDP growth will average 3% or higher for 2015. The consumer sector should lead the way, benefiting from lower energy prices and still-low interest rates. We expect consumers to contribute 2% to 2015 growth. The corporate sector could contribute roughly 1.25% from investment spending, given high corporate confidence and healthy balance sheets. Government spending should move from a modest drag to a modest contributor to growth and may account for an additional 0.25%. And the one negative for growth in 2015 looks to be a decline in exports, which we think will subtract around 0.5%.
Adding all of those numbers together would get the United States to a 3% growth level.
Outside of the United States, growth appears to be less robust. Thanks to ongoing easing efforts, we expect growth in Europe and Japan to slowly improve, but those economies still face difficulties. Chinese growth is decelerating, with nearly all facets of that country's economy facing pressure. The trend of divergence that emerged last year is likely to persist through 2015.
WHAT DOES THIS MEAN FOR INVESTORS?
First, we believe the current weakness in equities will pass, but probably not until commodity prices stabilize and the associated deflation fears ease. The fundamental strength of the economy — along with the combination of benefits that should come from lower oil prices and a stronger dollar — should push equity prices higher this year. Market volatility is likely to persist, but we believe equities should outperform cash, bonds, commodities and inflation in 2015.
Getting security selection right will be an important theme this year, since we expect further divergence between winners and losers. In particular, we think companies with high levels of free cash flow look attractive, and we skew our sector preferences away from commodity producers (including energy) and toward commodity users. We also believe that companies with earnings that are more dependent on domestic revenue sources will outperform globally-oriented companies.
Robert C. Doll is senior portfolio manager, chief equity strategist at Nuveen Asset Management. This commentary originally apeared here.
