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Watch Out For 2 Side Effects Of The Economic Recovery

Thursday, April 24, 2014 - 4:15pm

As I noted earlier this week, the U.S. economy appears to have exited the winter slowdown in robust fashion.

Coupled with firmer employment trends and a more positive outlook for corporate spending, there is reason to believe that we may see the economy grow at pace last seen back in 2005, when growth exceeded 3%. We'll need to finish this year on a strong note for that to happen, but it's a clear possibility.

U.S. GDP Growth

Still, robust economic growth won't necessarily translate into strong gains for all kinds of stocks. As I noted a few days ago, value stocks, many of which have leverage to a firmer economy, are more in favor these days, and high-priced growth stocks are stumbling.

In fact, some pockets of the market will actually suffer in a stronger economy. Here's what you need to know.

Rising Rates
Nearly six months ago, I noted that the interest rate yield curve will give a clear picture of a firming economy. To be sure, the 10-year Treasury isn't yet reflecting an economic pickup, with the yield currently around 2.75%.

Yet it's important to understand that economic growth in the 2.5% to 3% range is historically consistent with 10-year interest rates in the 4% to 5% range. The dismal first quarter may be holding interest rates back, but that may soon change.

Rising rates would bring fresh pressure on any income-producing stocks such as utilities, REITs (real estate investment trusts) and MLPs (master limited partnerships). When it comes to dividends, we continue to think that dividend growth will prove to be more appealing than absolute dividend yields.

What about the Federal Reserve, which has repeatedly stated that short-term interest rates won't budge until the economy is much healthier? The Fed would only start hiking short rates if it thought that a stronger economy creates inflationary pressures.

In a landmark study conducted by the Dallas Fed, such inflationary pressures emerged when our factors operate closer to full capacity. "Typically, utilization rates above 82 percent have signaled higher inflation brought on by the onset of production bottlenecks and supply shortages," the authors note.

According to the Fed, that figure fell to just 66.9 in 2009, moved into the low 70s in subsequent years, and is now fast-approaching the 80% mark. Several quarters of sustained economic growth may push us into the low 80s. That's why talk of rate hikes may arrive in 2014, and not further down the road as many currently expect.

Peaking Margins?
As industry bottleneck pressures emerge, the cost of doing business starts to rise. Some companies hike their own prices in response, though in many industries, a lack of pricing power forces companies to take a hit to margins. Profit margins may also take a hit as companies start to add to staff, which I discussed in my prior look at the resurgent economy. So rising sales might not produce a commensurate rise in profits.

Bubbling Crude
A stronger U.S. economy tends to correlate with higher oil prices. The U.S. consumes 18.5 million barrels of oil per day, which is equivalent to the total consumption of China, India and Japan (though the combined population of those three countries is eight times larger). So despite a steady migration towards more efficient cars and trucks, a rising U.S. economy is bound to sop up some of the marginal excess supply of global oil production. The fact that current oil prices stand above $100 before U.S. economy activity has begun expanding at a faster pace means we may be looking at crude oil prices in the $110 to $120 range by year's end (though that would likely entail an equally vigorous Chinese economy).

Though higher fuel prices impact many businesses, few are as exposed as the airlines. In my recent pan of United Continental (NYSE: UAL), I noted that "a $0.15 move in jet fuel prices could negatively impact EPS by roughly $1.50. The carrier has likely hedged some fuel prices, but doesn't divulge specific data. But in effect, if crude oil prices moved up to $110 a barrel, much of United's profits would dry up."

Higher jet fuel prices would sharply erode profits at other airline carriers as well, at least those that don't have strong fuel price hedges in place.

Consumers may also feel the pain at the pump. Gasoline prices are already up $0.12 a gallon from a year ago (to a national average of $3.63) according to gasbuddy.com), and we haven't even reached the peak driving season yet. Higher gasoline prices are partially attributable to a surge in gasoline exports to Europe and elsewhere.

Risks to Consider: The late-quarter rebound is partially due to inventory restocking after the polar vortex, and it's always wise to see several months' worth of economic data points to confirm that a sustainable economic rebound is underway.

Action to Take --> This is a good news/bad news scenario. For the most part, economic growth would have a beneficial impact on stocks, especially in cyclical industries. But the low-rate environment that underpinned this extended bull market may also start to melt away. Between higher interest rates and higher oil prices, economic activity will start to be impacted.

P.S. America's wealthiest investors have used MLPs and REITs to generate safe, rising income for years. But in our latest High-Yield Investing research, we've found another little-known group of investments the wealthy have used to generate dividend yields of 12% or more for decades. To learn more about these special investments, go here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.