05/18/2015 | David Joy

The S&P 500 closed at an all-time high on Friday, despite a series of economic reports that suggested the expected second quarter rebound was nowhere in sight. While this may be good news to those who would prefer that the Fed not raise rates anytime soon, it does cause us to re-examine our assumptions of how this year is likely to unfold. We may arrive at the same destination, but how we get there may be very different from what we expected just a few short months ago. Albert Einstein's exhortation to "question everything" now seems particularly appropriate.

Roughly halfway through this year's first quarter it became apparent that economic activity would fall short of expectations. But, this acknowledgement was largely dismissed as having been caused by events that would simply postpone economic activity until the weather got better and backed-up goods at West Coast ports started moving once again. In fact, many pointed out that the very same thing happened last year, when U.S. GDP contracted at an annualized rate of 2.1 percent, only to be followed by a burst of activity in the second and third quarters of 4.6 and 5.0 percent.

The key to this year's rebound was going to be U.S. consumers, who had spent the previous six years repairing their balance sheet, and who were benefitting from a strong rebound in job growth and lower gasoline prices. Years of delayed gratification were expected to turn into increased spending.

The Consumer is Nowhere in Sight

It has now been two months since those first quarter "transitory" headwinds have dissipated and the consumer is nowhere in sight. Last week, it was reported that retail sales in April were flat compared to March, after having contracted in the first quarter for the first time in three years. And, the University of Michigan's survey of consumer sentiment unexpectedly turned lower, despite the unemployment rate having fallen to a seven year low of 5.4 percent.

An important component of the expected upturn in consumer activity would be housing, as years of sluggish demand and a recent upsurge in household formations would unleash pent-up demand. Yet, in March new home sales and housing starts and building permits disappointed.

The Dollar Continues to Decline

Reinforcing the idea of a consumer-led rebound was the expectation that the dollar would remain strong, as the anticipation of a first Fed rate increase would contrast with the stimulative monetary policies in much of the rest of the world, pulling capital in search of yield into the U.S. from overseas. This dollar strength was believed to favor companies that derived the majority of their revenues from the domestic economy, including consumer groups, while those more reliant on overseas revenues would suffer. A stronger dollar was also expected to keep energy and other commodity prices under pressure. However, after rising 11 percent from the start of the year through March 13, the DXY Dollar Index has fallen 7 percent since, and North Sea Brent crude oil is up 17 percent. Investors are once again looking at multinationals.

Wage Pressures Causing Concern

At the very least, we could expect wage pressures to rise as unemployment fell toward the longer-run normal rate, which the Fed now projects at 5.0-5.2 percent, nudging overall inflation toward the Fed's 2.0 percent target. Together with the expected economic rebound starting in the second quarter, these pressures were expected to cause the Fed to raise rates in September, and perhaps as early as June if the rebound was strong enough.

Yet, wage pressures are causing little concern. Year-over-year average hourly earnings in April were higher by just 2.2 percent. The broader employment cost index wage component did rise at its fastest pace in six years in the first quarter, but even here the year-over-year gain was just 2.8 percent, encouraging but not terribly inflationary. The core Personal Consumption Expenditure (PCE) deflator, the Fed's presumed preferred measure of inflation, rose just 1.3 percent in March. Given the modest rebound and absence of inflationary pressure, any possibility of a June rate hike is long since gone, and now September is appearing to be increasingly less likely.

We may still achieve our 2,250 year-end S&P 500 target, but the path that gets us there now appears to be quite different from how it looked five months ago. Rather than steady quarterly economic growth near 3.0 percent, it now appears that first quarter activity was actually negative. Instead of a sharp rebound in the second quarter, we now expect firmer activity to emerge in the second half. And the most important implication of this slower pace of growth, should it persist, is a Fed that may be on the sideline for longer, altering expectations regarding the dollar and the market sectors that will impact.

Important Disclosures:

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

University of Michigan Consumer Sentiment Survey is a rotating panel survey based on a nationally representative sample that gives each household in the coterminous U.S. an equal probability of being selected. Interviews are conducted throughout the month by telephone. The minimum monthly change required for significance at the 95% level in the Sentiment Index is 4.8 points; for Current and Expectations Index the minimum is 6.0 points.

The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

Ameriprise Financial Services, Inc. Member FINRA and SIPC.
distributed by