Market Perspective for April 17, 2015

Earnings season started off positively this week with companies across several industries reporting strong results. Some of the biggest winners, in terms of the reaction from investors, were Netflix (NFLX) and Philip Morris International (PM). Other companies beating estimates were Johnson & Johnson (JNJ), Goldman Sachs (GS), Bank of America (BAC), J.B. Hunt (JBHT) and Intel (INTC), a good cross section of the American economy. General Electric (GE) disappointed with a revenue miss, though earnings did beat estimates.

The most important earnings report of the week is probably Schlumberger (SLB), which beat estimates by 15 percent. Coming into earnings season, analysts were looking for energy sector earnings to plunge about 60 percent versus last year’s quarter, mainly due to lower oil prices. This sizable decrease was responsible for pulling the estimate for S&P 500 earnings down to nearly negative 5 percent. SLB’s earnings only declined 10 percent versus last year though. If that’s a harbinger for the energy sector, earnings growth will be much better than expected this earnings season.

Even with the positive news, due partially to the latest inflation numbers, the market gave back all of its gains on the week in early Friday trading. Bonds also reacted poorly to the report, while the U.S. dollar rallied, due to investors interpreting the results as supportive of interest rate increases.

We’ve been talking about a much stronger inflation number in March for several weeks now. The government report actually came in below expectations, which is surprising because the data we follow has been highly correlated with later government reports. However, while the government’s number was a bit lower than expected, the composition of inflation suggests price inflation is firming because it occurred in sectors that are not volatile.

The Federal Reserve concentrates on core inflation because food and energy prices move significantly, as we saw with oil in recent months. Lately, core inflation has firmed, with rents and medical care playing a role in rising prices. The latter may be due to the wider implementation of the Affordable Care Act, which is a healthcare cost inflation machine. The ACA increases healthcare demand and spending (via higher insurance prices and government aid), without increasing the supply of services. Anytime demand rises faster than supply, prices will increase.

Rising medical costs are troublesome because of a lack of market forces. When oil prices go up, people try to consume less oil. At least half of healthcare spending is done by government and consumers must buy health insurance plans, with low cost plans deemed illegal by the law. Politicians won’t respond to higher costs by suggesting spending cuts, in fact they’re more likely to increase spending. Consumers can’t opt for cheaper health insurance plans that no longer exist, and if they can’t afford the plans, the government increases spending to subsidize the cost. Price increases lead to higher spending, which leads to higher prices, which again leads to higher spending. It’s a similar situation that fuels college tuition cost: government reacts to higher prices by spending more money on higher education. However, while college education is a small part of the economy, healthcare is one-seventh of the economy and growing. If inflation takes hold there, it will force up wages in the sector, and eventually the entire economy will be experiencing higher rates of inflation.

Healthcare stocks, led by biotechnology and pharmaceuticals, have been leading the market the past couple of years and it’s also the best sector in 2015. If medical costs inflation does become an issue, this sector is positioned to continue its bull run much longer than anticipated.

Aside from stronger inflation, U.S. stocks reacted to overseas markets on Friday. Chinese stock market futures are down about 7 percent following new regulations in China. Regulators are tightening the use of credit in the market, and they’re also making it much easier for investors to take short positions. The dip follows an almost uninterrupted doubling of the Chinese stock market over the past nine months. Europe is also taking a breather after its quantitative easing fueled rally. The German DAX index lost more than 5 percent this week, about half of that on Friday. Despite this week’s drop, the DAX is up more than 20 percent in 2015.

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