CONSUMERSTRENGTH

C o n s u m e r S t r e n g t hBackbone Of A Continuing Economic Expansion

I N V E S T M E N T S T R A T E G Y G R O U P

Mark Luschini Chief Investment Strategist

Michael J. Halloran, CFA Strategy Analyst

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Importance of Consumer to Economic GrowthThe U.S. consumer is the most important part of the economy with consumer spending making up about 68% of the U.S. economy. This figure dwarfs the remainder of the economy—consisting of in-vestment, government purchases, and net exports (exports minus imports). Consumer spending includes purchases of everything from cars, homes, and insurance to groceries and health care. This spending is vital to economic growth with the things we buy creating the demand that helps companies grow profits and hire new workers. Companies with growing profits ultimately support higher stock prices.

Figure 1: Relationship Between Stock Price Performance and Economic Growth

Anatomy of The U.S. Consumers’ Return To Health

Lower Debt Levels:Consumer borrowing plays a major role in eco-nomic growth. This borrowing supports the purchase of homes, autos, education, and more. But too much borrowing can be a bad thing. Leading up to the financial crisis, consumers supplemented their spending by borrowing more than they could afford. This was unsustainable and played a major role in the crisis. Since the crisis, consumers have made significant progress on re-ducing their debt levels and are well positioned to support economic growth.

We are now six years into the current economic expansion and a rising stock market. A question we are frequently asked is: What can keep the economy and stock market going and how will this be accomplished? We think the consumer is the key to future economic growth and positive stock market performance. This piece examines the health of the consumer and concludes that a healthy consumer can underpin further economic growth and stock market gains.

Rising Stock Prices Depend on Consumer-Led Economic Growth

(Source: Janney ISG, Bloomberg)

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S&P 500 Index (LS) GDP Growth (RS)

Weak Consumer led to Recession and Falling Stock

Prices. Rising Stock Market caused by Consistent Economic Growth and

Improving Consumer.

Figure 2 shows consumer debt rising to unsustain-ably high levels leading up to the financial crisis and also shows the significant progress that has been made toward reducing debt to sustainable levels. This debt reduction process (known as de-leveraging) resulted in sluggish economic growth as consumers paid down debt instead of making purchases. The good news is that this process of

Figure 2: Significant Progress has been Made Toward Sustainable Consumer Debt Levels.

Consumer Debt Levels

(Source: © BCA Research 2014, Congressional Budget Office [CBO])

Consumer debt climbed to unsustainable levels before crisis.

Rising consumer debt provided a tailwind to the ‘80s and ‘90s

economic boom.Consumer debt is now at a

lower, sustainable level.

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Figure 4 shows unemployment has fallen from a peak of 10% to a much healthier current reading of 5.4%. We have created over 12 million jobs since the crisis and are beginning to see wage growth accelerate. A solid labor market is a key pillar sup-porting consumer confidence and spending.

debt reduction is largely over, with consumer pur-chasing power now in a much healthier position.

Supportive Federal Reserve:The Federal Reserve also played a significant role in helping the de-leveraging process with extremely low interest rates since the crisis. Figure 3 shows that the household debt service ratio (total required household debt payments to total disposable in-come) is now at historically low levels. This is thanks to lower absolute debt levels and record low interest rates. This historically low level of debt service puts the consumer in a good position to make major future purchases like homes and autos.

U.S. Household Debt Service Ratio

(Source: Janney ISG, Bloomberg)

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Figure 3: Household Debt Service Levels are Now at Historical Lows and Well Positioned to Support Consumption.

Debt service rose to unsustainable levels before the crisis.

Historically low levels of debt service can now support healthy consumption growth.

Healthy Labor Market:Improvement in the labor market has also helped the consumer.

Figure 4: The Labor Market Has Been Making Steady Improvement since the Crisis.

U.S. Unemployment Rate

(Source: Janney ISG, Bloomberg)

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A much healthier labor market is key to future consumer spending.

Labor markets have returned to health.

Pent-Up Demand:While the consumer was paying down debt, they were delaying purchases of many goods and ser-vices. This created pent-up demand that should continue playing a major role in supporting economic growth in the coming years. Housing is probably the best example of pent-up demand and is shown in Figure 5. We expect housing activity to gain momentum throughout 2015 and beyond due to better job security and wage gains, low mortgage rates, and an improving household formation rate that has been very depressed.

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Figure 5: Housing Continues to Heal from the Financial Crisis Collapse with Lots of Pent-up Demand.

U.S. New Homes Sold (Annual)

(Source: Janney ISG, Bloomberg)

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Significant pent-up housing demand is slowly

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Figure 6: Record High Household Net Worth Supports Confidence and Consumer Buying Power.

U.S. Household Net Worth (Nominal USD)

(Source: Janney ISG, Bloomberg)

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Record high consumer net worth.

Figure 7: A Six-year Economic Expansion with Solid Labor Markets, Record High Net Worth with Lower Debt is Causing Consumer Confidence to Rise.

Conference Board Consumer Confidence

(Source: Janney ISG, Bloomberg)

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Consumer confidence continues to grind higher.

Record High Consumer Net Worth:While economic growth has been weaker than most everyone would like, it is resulting in higher home and stock prices that has propelled household net worth to record levels as shown in Figure 6.

Improving Confidence and Consumption:All of this is resulting in improving consumer and business confidence that should support consumer spending and business investment in the coming years. Figure 7 shows Consumer Confidence grind-ing higher from the lows of the financial crisis to much healthier levels today. A healthy, confident consumer with solid job prospects is resulting in a recovery to trend levels of consumer spending as shown in Figure 8.

We think this pace of consumer spending is sus-tainable in the coming years and should ultimately result in increasing corporate profitability that will support higher stock prices.

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Figure 8: A Healthy Consumer Leads to Rising Consumption That Underpins Economic Growth and Higher Stock Prices.

U.S. Personal Consumption

(Source: Janney ISG, Bloomberg)

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YOY Change

Healthy consumer is leading to steady consumption.

Actionable Investment Ideas:There are several sectors of the economy with stocks that should benefit disproportionately from sturdier consumer balance sheets.

Consumer Discretionary:This sector is an obvious winner and recent data suggests that consumers are allocating a larger share of their incomes to discretionary spending. In addition to housing mentioned above, other industries are benefitting. Restaurants are particu-larly well positioned with sales growing at their fastest pace in more than a decade. Fundamentals for lodging are also bullish with consumers spend-ing more on leisure and travel.

Financials:Financials are benefitting as consumer credit quality continues to improve and non-performing loans continue to fall. With an improving economy and stronger balance sheets, banks are well posi-

tioned to lend. Meanwhile, consumer demand for home and auto loans continues to improve. More readily available credit (and demand for it) has typically been a leading indicator of financial sec-tor profit acceleration. Banks, insurers, and credit card companies are all benefitting from increased activity while valuation remains supportive.

Health Care:Health care spending is outpacing consumer spending which typically leads to health care earnings outperformance and improving valua-tions. The pace of health care expenditure growth should continue to exceed that of the overall economy—with pent-up demand for health care services, lower unemployment levels, rising commercial insurance membership, and aging demographics bolstering the sector.

Table 1 shows the actionable investment ideas that should benefit from this healthier consumer.

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Company Name Ticker Forward P/E

Earnings Growth

Dividend Yield

Credit Rating Notes Coverage

Consumer Discretionary

The Consumer Discretionary sector is the major beneficiary of a strong consumer with lots of industries showing strong fundamentals including home builders, hotels, restaurants, and media.

CHIPOTLE MEXICAN GRILL INC CMG 34.84 20.59 - - Gaining share with superior combination of growth and store level returns. S&P/CS/J

MCDONALD’S CORP MCD 19.79 7.44 3.44 A- Largest fast food restaurant in the world with significant dividend. S&P/CS/J

WALT DISNEY CO/THE DIS 20.53 11.66 2.09 A Iconic consumer brands with a strong management team. S&P/J

COSTCO WHOLESALE CORP COST 26.43 10.27 1.11 A+ Consistent earnings track record with strong cash flow and balance sheet. S&P/CS/J

MARRIOTT INTERNATIONAL -CL A MAR 24.48 14.12 1.01 BBB Benefitting from strong fundamentals and returning capital to shareholders. S&P/CS

APPLE INC AAPL 14.35 15.63 1.43 AA+ Apple platform has over 90% customer retention while returning shareholder cash. S&P/CS

AMAZON.COM, INC AMZN 124.80 45.97 - AA- E-commerce continues to take share and AMZN is the dominant force. S&P/J

CONSUMER DISCRETIONARY SELECT ETF XLY - - - - Offers diversified exposure to 87 Consumer Discretionary

stocks.

ISHARES U.S. HOME CONSTRUCTION ETF ITB - - - - Offers diversified exposure to 38 home construction stocks.

Financials

The Financial sector has healed from the financial crisis and is well positioned to extend the needed credit and insurance for pent-up consumer expenditures.

ALLSTATE CORP ALL 12.15 8.73 1.68 A- Solid returns, valuation support and is returning cash to shareholders. S&P/J

DISCOVER FINANCIAL SERVICES DFS 10.93 9.38 1.62 BBB- Industry leading revenue growth, solid credit quality and buying back shares. S&P/CS/J

JPMORGAN CHASE & CO JPM 11.04 5.85 2.42 A Top management and deep bench with risk reduction as a catalyst. S&P/CS

WELLS FARGO & CO WFC 13.45 11.63 2.49 A+ Solid management and well positioned for consumer credit needs. S&P/CS

SIMON PROPERTY GROUP INC SPG 32.54 7.34 2.94 A Real estate that is well positioned for a healthy consumer. S&P/CS

FINANCIAL SELECT SECTOR SPDR ETF XLF - - - - Includes 88 stocks for broad-based financial sector exposure.

SPDR S&P REGIONAL BANKING ETF KRE - - - - Includes 90 equally-weighted regional bank stocks.

ISHARES U.S. INSURANCE ETF IAK - - - - Includes 64 U.S. insurance provider stocks.

Health Care

The Health Care Sector is a major beneficiary of job growth, increased insurance coverage (Obamacare), an aging population, and future high levels of healthcare spending.

MEDTRONIC PLC MDT 17.92 8.00 1.55 A Very diverse product line, strong cash flow, valuation and dividend support. S&P/CS

BRISTOL-MYERS SQUIBB CO BMY 44.12 18.43 2.12 A+ Multiple catalysts driving Immuno-Oncology franchise. S&P/CS

MCKESSON CORP MCK 18.90 12.23 0.40 BBB+ Drug distribution benefitting from strong pricing with cross-sell opportunities. S&P/CS

GILEAD SCIENCES INC GILD 10.29 8.39 - A- HCV market still in early stage while stock is trading well below historical levels. S&P

HCA HOLDINGS INC HCA 15.48 11.36 - - Hospital fundamentals are solid with HCA levered to many growth categories. S&P

VANGUARD HEALTH CARE ETF VHT - - - - Cap-weighted basket of 318 companies offers broad exposure.

ISHARES U.S. MEDICAL DEVICES ETF IHI - - - - Cap-weighted basket of 49 manufacturers and distributors.

ISHARES U.S. HEALTHCARE PROVIDERS ETF IHF - - - - Cap-weighted basket of 50 health care providers.

ISHARES US PHARMACEUTICALS ETF IHE - - - - Cap-weighted basket of 41 pharmaceutical companies.

Definitions:Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters.Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the company’s next full business cycle (typically 3-5 years).Dividend Yield - Trailing 12 month dividend per share divided by share priceCredit Rating - Rating assigned by Standard & Poor’s to the long term obligations of the issuer if repaid in the local currency of the issuer.

Table 1: Actionable Investment Ideas Driven by Consumer Strength.

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