Morningstar's Midyear Market Checkup

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the Federal Reserve set to raise rates for the first time in nearly a decade and continued growth worries in Europe, China, and elsewhere, the second half of 2015 looks set to be anything but quiet.

I sat down with several Morningstar experts recently to get their takes on both the first half of 2015 and what investors should be keeping an eye out for in the second half of the year. First up was Bob Johnson, Morningstar's director of economic analysis. He gave his thoughts on where GDP growth would be for the full year, when the Federal Reserve will act, and what impact higher interest rates will have on the economy.

Bob Johnson: Overall, I expect GDP growth for the full year to come in at 2% to 2.5%, as it has for the last four years. Very much in the stable pattern that it has been in. Now, there will be more growth in the second half of the year, where I think we could average as much as 3% growth in the last three quarters of the year versus the negative growth in the first quarter, which was the result of weather and a port strike. So, we will have a bounceback. That bounceback will not be as dramatic as it was in 2014 because we didn't have the big inventory drawdown that we had in 2014 when so many factories were closed and we had to rebuild. This year, the cold weather affected more of the buying than the production.

In terms of inflation, for 2015, I expect inflation to come in between the 1.8% and 2.3% level, which would represent a slight acceleration, and certainly higher than where we are at this very moment. As we lap the gasoline price decline--and, in fact, gasoline prices have now started to move back up again--it's going to start being a drag instead of a positive on the economy as we move into the back half of the year. So, that is something that I worry about, and I think that the underlying rate of inflation, which is probably about 1.5% to 2%, will become very visible by the end of the year when we completely lap the gasoline price decline.

Employment growth was exceptionally strong at the end of 2014, where we had almost boomlike conditions in the hiring market. We slowed in the first half of 2015. For full-year 2015, I think we're going to get back to that 230,000 to 250,000 jobs added per month, on average, that we've seen over the last couple of years. We may see an occasional month of 300,000 or sub-100,000 jobs added; but overall, with the economic growth I'm anticipating, we shouldn't vary too far from the 230,000 to 250,000 per month on a more extended basis.

I expect job growth to continue over the next several years because employment generally moves with GDP growth and I've got a very stable 2.5% GDP growth forecast in the years ahead. I would expect employment growth to be just modestly under that. So, that's certainly good news in the employment sector. And certainly, with so many baby boomers retiring and a lot of the demographics, we may actually see some labor shortages. That may hold us back--not having enough workers more than not having enough jobs--over the next two or three years.

There are a couple of key drivers going on in the economy right now. One is that manufacturing is slowing. It had a boom year in 2014, but autos aren't growing as fast as they were, exports aren't growing as fast as they were, and commodity-related manufacturing has gone down. So, manufacturing is having a bad year in 2015. We are very hopeful that housing will help offset some of that.

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In the first few months of 2015, it hasn't; but the early signs--the pending home sales, the new homes sales of homes not even started yet--are beginning to show signs of booming and should provide some relief in the second half. So, certainly, some things seem better there. I've mentioned the consumer has been doing a little bit better. Business, on the other hand, remains very conservative. Instead of investing in new plant and equipment--which is at a relatively low level right now and really hasn't improved very much--the money is being spent on mergers and acquisitions and on stock buybacks. So, they have failed to spend some of the cash that they have.

Consumers have shown a similar restraint. They also haven't spent all of their cash. The savings rate is more in the mid-5% range versus the more recent average of about 4.5%, indicating some caution on their part as well. So, performance in the economy in the back half of 2015 and into 2016 really depends on whether consumers will spend the money that they already have. Will they go out and seek additional loans to purchase other things to help accelerate the economic growth rate in the months and years ahead?

Overall, the Fed is always a big question. Looking ahead, I think they will indeed raise rates in 2015, perhaps as much as twice--once in September and once in December. I don't think they are going to raise them by a lot, perhaps 0.25% or 0.5% each time. But I do think that they want to move rates higher, and I do think the economy is strong enough to survive that.

I do point out that it's very data driven. If for some reason the economy slows down a bit because of the situation in Europe or things become more unsettled or consumers remain in their shell and businesses continue to do buybacks instead of investing in plants and economic growth slows, maybe they put off those rate increases. They are very dependent on the data. It's not what day it is; it's not one factor but a sense of factors combined that are going to drive their moves in the months ahead.

I do think that because they view what they've done so far as relatively extraordinary, they kind of want to get the economy off life support as soon as they possibly can. We've already got the bond buying behind us. I think they want to get moving on moving rates up. But if the economy hits a little stumbling point here, they won't hesitate to push off the interest-rate rise.

So, we've talked a little bit about the Fed potential for raising rates and the necessity perhaps for them to raise rates; but the question is can the economy sustain that growth in light of Fed rate increase. I certainly think they can. I think we haven't seen a big boom in things because of low interest rates and, likewise, I don't think we are going to see a big collapse when rates move modestly higher.

It's going to affect housing affordability a little bit; but certainly the moves we've seen already haven't been enough to really slow the housing market. In fact, what often happens is that, as the Fed threatens to raise rates, people rush to lock in rates. People who have been sitting on the fence for a couple of years asking why should they rush now see the potential need to act quicker with rates moving higher. It actually, in the short run, can help move some economic activity forward.

Glaser: What will the slow-but-steady economic growth mean for stock investors? We asked Morningstar StockInvestor editor Matt Coffina for his take on current valuation levels, what he expects in terms of returns, and if there were any sectors that look attractive today.

Matt Coffina: I think stock valuations are relatively rich compared with history. For example, there are three measures that I often look at: the price/earnings ratio for the S&P 500, using trailing 12-month operating earnings; the Shiller price/earnings ratio, which would use a 10-year average of real inflation-adjusted earnings; or the price/trailing peak operating earnings, which basically compares the current price with the peak for earnings historically. Along any of these three measures, stocks have been cheaper, on a price/earnings basis, about two thirds to 75% of the time over the past 25 years.

If you went even further back in time, stocks would look even more expensive relative to history because the last 25 years have generally involved elevated stock market valuations. Valuation levels definitely have an impact on future total returns, but it's mostly over a five-year or longer time frame. They tell you very little about what stocks are going to do over the next, say, six months or year. So, even if stocks are very expensive right now, they could easily get more expensive over the next year. If stocks were very cheap, they could get cheaper. So, for example, current valuation levels were seen around 1996, and the bubble would go on to inflate for another four years before we had the crash.

But over a five-year time frame, valuation levels can definitely have an impact, and I would think of that as coming really from three channels. First of all, higher valuation levels mean lower dividend yields, so you are earning less dividend income over time. They also make it less likely that price/earnings multiples will increase in the future, and that has been a modest source of return historically. The S&P's price/earnings ratios tended to increase over the very long run. And it also makes it more likely that price/earnings multiples will contract, in which case your returns could easily be below earnings growth and dividend income, which you might think of as sort of baseline for returns.

At the moment, I'd say there are two sectors that really stand out as being out of favor to me. Those would be transportation stocks: railroads; to a lesser extent, trucking, airlines; really anything logistics; anything linked to transportation. And then any rate-sensitive stocks: utilities, midstream-energy companies, real estate investment trusts. These areas have both been underperforming, which is interesting to observe because the first group, transportation, you would think is very economically sensitive.

The latter group, the more rate-sensitive stocks, tends to be economically defensive. So, it's a little surprising to see both out of favor at the same time; but I'm seeing opportunities in both of these areas. I'm looking at, for example, some high-quality railroads as well as some higher-yielding REITs--health-care REITs, for example--utilities which we thought until recently were significantly overvalued. We are starting to see some pockets of opportunity open up there as well.

Glaser: Bond investors have been on edge for years now trying to figure out how to deal with this unusual interest-rate environment. Morningstar analyst John Gabriel shared some of the big themes he's seen so far in 2015.

John Gabriel: Earlier in the year, amid the Greek debt crisis and general negative sentiment across the eurozone, investors desperate for safe-haven assets drove nominal yields on European sovereign bonds into negative territory. Other major themes thus far in 2015 have included sharpened liquidity concerns in the otherwise rebounding domestic high-yield market.

After being ravaged in the second half of 2014 amid collapsing energy prices, junk bonds were atop of the list of best-performing bond categories, year to date. The most volatile and worst-performing bond categories, however, have been long-term bond and long government, as investors have been eager to shed duration risk ahead of a potential rate hike. But despite all the challenges facing fixed-income markets, the intermediate-term bond category has been flat so far in 2015.

Glaser: But what are the prospects for high-yield going forward? Morningstar's Dave Sekera thinks that high-yield will continue to outperform sectors that are more interest-rate sensitive, but he has an important caveat.

David Sekera: In our first-quarter outlook that we published late last year, we made our case on why we expected the high-yield market to outperform investment-grade this year. Looking to the second half of the year, we continue to expect that high-yield will provide a better return than investment-grade as the high-yield segment has a much lower correlation to underlying interest rates than investment-grade bonds do, and it's much more dependent on economic conditions.

The greatest near-term risk to our outlook would be if oil prices started to slide back down into the low [$50-per-barrel range]. In that environment, we would expect that the credit spreads for high-yield energy and energy-services companies would widen considerably, as default risk would be heightened at that dollar level. So, considering that energy issuers are the single-largest sector within the High Yield Index, at over 14% of the index, that would be enough to push the average spread of the entire index wider.

So, for example, when oil prices bottomed out earlier this year, the average spread of the High Yield Index was 40 basis points wider than the current level.

Glaser: Finally, the muni-bond market has been on many investors' minds as scary headlines have been coming out of places like Puerto Rico and Illinois. Morningstar analyst Beth Foos provided us with her take on the state of the market.

Beth Foos: Municipal-bond funds have been on a bumpy ride in the first six months of 2015. This comes after a very solid year in 2014, both in terms of fund flows and returns. Unlike last year when supply was down, debt issuance in the muni market has been more robust in 2015, driven largely by issuers trying to capitalize on today's lower interest rates before the expected Federal Reserve rate hikes. That increased supply combined with higher Treasury yields and general concerns over rising rates have reduced demand and resulted in weaker performance among muni funds.

Year to date, the funds in our muni-national categories have been rather flat, with each category down between 0.1% and 0.2% through June 30. At the same time, funds in our high-yield muni category eked out a modest 0.3% gain over the same time period. With that, most of our muni-fund categories are still showing moderate levels of total inflows for 2015; but demand has faded more recently with most of those categories experiencing outflows in May and June. This was especially the case in the high-yield muni category where valuations have tightened and credit concerns have grown significantly around some of the larger, more-stressed issuers, such as the City of Chicago, the State of Illinois, and Puerto Rico.

Looking forward, the market will continue to watch headlines surrounding general economic conditions, the growing pension burdens across the muni market, and the increasing financial stress in Puerto Rico through the rest of the year.