Equities Show More Positive
Than Negative Signs
May 31, 2016
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The negative feedback loop that dominated financial markets earlier this year has faded and reversed.
There are a number of potential downside risks for equities, but we expect the positive factors will win out over time.
Market Trends Have Reversed for the Better
Early in 2016, financial markets were dominated by a negative feedback loop. Chinese economic conditions were deteriorating, which drove fears of global deflation. Oil prices fell as a result, which put downward pressure on credit markets, the banking system and the broader global economy. Those trends have recently started to reverse. Confidence in the global economy is growing, oil prices are rising and stabilizing, worries about Chinese currency devaluation are receding and credit markets appear healthier.
Global financial markets now appear in better condition than they did a few months ago. U.S. stock prices are approaching their cyclical highs and credit spreads have been narrowing.1 Investors remain jittery, however, and are focused on a number of near-term risks, including Federal Reserve policy, uncertain earnings and an unstable geopolitical backdrop.
Key Variables for Financial Markets
So what are the factors that are likely to determine the future direction of markets? We point to the following key variables:
The Global Economy: The world has proven to be quite resilient to shocks over the past few years, and we expect growth to improve modestly this next year. Should global manufacturing improve (and we expect it will), it would go a long way toward promoting better growth.
China: Authorities face a difficult task as they need to rebalance their economy while promoting growth. The stronger U.S. dollar is pressuring the Chinese economy, but we do not anticipate a hard landing.
The Federal Reserve: Given the more hawkish tone the Fed has recently adopted, the odds of a rate hike in June or July have risen. Fed action has the potential to trigger volatility in oil prices, the dollar and equity markets. But we do not believe disruptions will be overly significant.
Oil Prices: Production levels will likely remain high. We are not expecting to see cuts from OPEC, and U.S. production may drift higher over the coming year.1 We think oil prices will remain range bound, but the risk of another rout in prices cannot be ruled out.
Credit Spreads: Many fear that the U.S. credit cycle is in the late stages, which has triggered on-and-off selling pressure for high yield debt. We believe credit conditions are improving and high yield markets continue to look attractive, which would be a positive sign for the economy and equities.
Corporate Earnings: Earnings have been in a year-long decline. We think headwinds are fading, but investors need to see evidence that earnings results can turn positive. We are seeing forward guidance turn positive in key sectors such as industrials,1 and we expect better earnings results in the second half of this year.
Politics: There are a number of geopolitical events that could rattle financial markets, including the referendum on the U.K. leaving the European Union and the upcoming U.S. elections. High levels of uncertainty are a negative for risk assets, and the political backdrop is anything but certain.
Equity Markets May Be Poised for Outperformance
On balance, we see more positives than negatives for equity markets. A number of potential downside risks exist, with the two most prominent being questions over Fed policy and the rising value of the dollar. These factors could weigh on stock prices in the near term, particularly given uncertainty over global economic growth and corporate earnings.
Nevertheless, we have a positive long-term outlook for equities and believe they will outperform bonds and cash over the next six to twelve months. Should we see a price breakout to the upside, that would be a clear bullish sign, and could lead investors to believe that the downtrend evident over the past year has faded.
It would be a mistake to discount the risks to equities, but we believe it might be a bigger mistake to discount the positives.
Last Week's Commentary
Economic Growth and Inflation
Are Both Moving Higher
May 23, 2016
Investor attention has been focused on the Fed, as the prospects have risen for an earlier-than-expected rate increase.
Despite weak earnings results, we believe consumer spending remains solid, which should help the broader economy.
Corporate earnings should improve in the second half of 2016, providing a tailwind for equity prices.
U.S. equities were mixed last week. The S&P 500 Index snapped a three-week losing streak and climbed 0.4%, while the Dow Jones Industrial Average was down fractionally.1 The biggest story last week was a growing sense that the Federal Reserve might begin raising interest rates sooner than previously anticipated. Corporate earnings were also in focus, with retailers continuing to show poor results.
Weekly Top Themes
The minutes from the April Fed meeting were slightly more hawkish than anticipated. The Fed indicated that markets were overly complacent about the prospects for near-term rate hikes. The Fed continued to suggest that two rate hikes might occur in 2016, but there appears to be a greater possibility of the first increase happening as early as June or July.
Fears of deflation have eased significantly since the beginning of the year. Global growth has shown signs of improvement, worries about China devaluing its currency have faded and oil has rebounded notably. All of these factors have dramatically reduced global deflationary risks.
Inflation is slowly starting to advance. The Consumer Price Index rose 0.4% in April, the sharpest increase since February 2013.2 Gasoline prices showed a dramatic rise of 8.1% for the month.2 In our view, the recent increase in commodity prices should push headline inflation to around 2% during the second half of this year.
Despite weak earnings from retailers, overall consumer spending remain solid. A main corporate earnings theme for the first quarter was pronounced weakness in traditional brick-and-mortar retailers, particularly clothing and department stores. Overall retail sales, however, appear to be growing. Part of this apparent disconnect is due to the fact that consumers are still spending money on online purchases and in areas such as home improvement. Second quarter retail sales are on track to increase at a 5% annual rate (in line with the first quarter).3 And consumer spending may rise from 1.9% in the first quarter to close to 2.5% in the second quarter.3
Although consumers are spending money, the savings rate is also rising. Just before the Great Recession, the U.S. savings rate was 2.5%, and it has since risen to over 5% today.3 This stands in marked contrast to a decades-long trend: From the mid-1970s through the beginning of the Great Recession, the savings rate trended lower as Americans spent beyond their means.3 The fact that U.S. consumers now have both healthy savings and spending patterns is good news for consumer spending and the broader economy.
Equity Market Variables Include Fed Action and Earnings
The Fed’s suggestion last week that additional rate hikes were on the horizon should not have come as a surprise, yet markets experienced a minor jolt. Investors remain wary about higher interest rates and continue to react (and overreact) to every Fed statement and hint. In some ways, the Fed itself is to blame for this phenomenon. The central bank waited so long (we would say too long) to enact its first rate hike in December, and has been highly attuned to financial market conditions as it ponders its decisions.
The Fed has clearly stated that any future moves will be data dependent. And additional rate hikes seem inevitable since economic growth appears to be improving and inflation is starting to rise. The exact timing, however, is unclear. The Fed is in a conundrum since it does not want to rattle investors, but is aware that rate hikes will do just that. When the next rate hike does occur, we expect it will cause additional market volatility, but we also believe that the economy and equity markets should be able to overcome any turmoil.
The main catalyst for equity prices remains the earnings backdrop. The quality of earnings has deteriorated over the past several quarters, but we do not believe corporate health is failing. As global economic growth regains traction, we expect earnings will improve, especially if we do not see a renewal of the oil rout/dollar rally trend. Equities are not inexpensive at present levels, but valuations are not stretched. Assuming corporate earnings can recover, we think it is more likely than not that equity markets will advance over the coming year.
1 Source: Morningstar Direct, as of 5/20/16
2 Source: Labor Department
3 Source: Cornerstone Macro