U.S. equities retreated last week, with the S&P 500 Index declining 1.0%.1 Sentiment was dragged down by negative earnings updates, a disappointing trade report from China and rising U.S. political turmoil. For the week, defensive and yield-generating sectors outperformed, while materials and health care lagged.1
While investors have focused on an increasingly contentious U.S. political backdrop, the global economy has been reasonably solid. Brexit spillover has not affected the rest of Europe, Chinese growth has remained relatively stable and the United States has been slowly accelerating.
Despite a reasonably decent backdrop, investors have been cautious and unwilling to take on more risk in their portfolios in recent years. This wariness is understandable given the high number of shocks occurring in this cycle, including the sharp collapse in commodity prices, the Greek debt crisis, China devaluing its currency, Brexit, widespread terrorism, geopolitical uncertainty and a fractious U.S. political backdrop.
As a result, stock prices have been trapped in a relatively volatile trading range, moving only slightly higher since the beginning of 2015. Looking ahead, we think the macro backdrop should be conducive for better equity performance. Global growth remains solid and corporate earnings should recover in the coming quarters.
For these trends to translate into firmer equity prices, investors must believe the global economic recovery and earnings cycles will become self-sustaining, meaning that equities will no longer be dependent on monetary policy stimulus. While we remain cognizant of all of these risks, we nevertheless advocate retaining a pro-growth but cautious investment stance.
Last Week's Commentary
What Factors Will Drive
Equities from Here?
October 10, 2016
Global monetary policy remains equity friendly, but policy is no longer sufficient to drive equity returns.
We believe the global economy and corporate earnings should improve modestly, if unevenly.
Equities should grind higher over the coming year, but selectivity is growing in importance.
The Monetary Policy Tailwind May Be Fading
During the height of the financial crisis, the Federal Reserve and other central banks stepped in to stave off complete global financial catastrophe. In the ensuing recovery, monetary policy has remained extremely accommodative and been largely responsible for an equity bull market that is nearly eight years old.
For now, monetary policy continues to be a driving force behind equity market performance. Policy alone, however, cannot produce a self-sustaining economic expansion or restore financial imbalances. Something needs to change.
Policymakers may have exhausted their playbooks by this time and are running out of ways to stimulate growth and provide financial stability, meaning the end of the easing era may soon be upon us. We do not expect imminent near-term shifts in global policy, and policy isn’t going to become equity unfriendly any time soon, but further significant gains in equity prices will require something else.
Economic and Earnings Growth Remain Critical
That something else is likely to be accelerated global economic growth and a corresponding earnings recovery.
Over the next year, we expect a gradual and broadly improving global growth trajectory, led by U.S. consumers and a revival in U.S. imports. The jobs market remains on track and incomes are rising, which should boost consumer spending. Summer retail sales were lackluster, but we expect better results ahead. Likewise, manufacturing data will likely improve. Outside of the United States, growth remains relatively weak. A revival in global trade would go a long way toward lifting global growth expectations.
At the same time, we anticipate that corporate earnings results should improve modestly. Given relatively soft growth and the oil/dollar headwind, corporate earnings struggled through most of 2015 and early 2016. We are starting to see a turnaround, however. After a long recession in earnings, S&P 500 earnings-pershare growth was up 1% in the second quarter, excluding energy.1 That’s a good sign and augers well for results in the coming quarters.
Looking ahead, we expect overall EPS growth to turn positive late this year or early in 2017 as the energy drag wanes. The still-sluggish economic environment, however, means that earnings will likely continue to struggle and remain uneven.
Equity Prices Should Grind Unevenly Higher
We remain mildly risk-on in our investment positioning, and expect equities and other risk assets to move higher over the next 12 months. A December Fed rate hike could spark some volatility, but shouldn’t derail the bull market as the Fed plans to proceed cautiously.
Central bank policy outside of the United States also bears watching. The Fed is the lone major central bank that is starting to shift to a tighter stance. Other global central banks remain firmly in easing mode, which should act as a partial anchor on Treasury yields. We think yields will likely rise as economic growth improves and as policy slowly starts to shift, but any advance should be gradual and not enough to act as a headwind for risk assets.
We understand investors’ desire to be cautious, given uneven economic growth and a host of geopolitical issues. We also acknowledge that equity prices are not as cheap as in recent years, making some investors reluctant to enter the markets. At the same time, we think equities look more attractive than bonds (particularly government bonds offering yields near historic lows) and cash, which is still offering close to 0% returns.
As the bull market matures, selectivity is growing in importance, suggesting this remains a
stock-picker’s market and one that we believe will favor active management. In our view, there are a number of different elements investors should consider when building equity portfolios. First, they should focus on the sustainability (and, perhaps more important, growth potential) of dividends. We expect more dividend increases in the future, if and when earnings become more stable. More broadly, we also favor domestically sourced earnings, cyclicals over defensives, dividend growth over dividend yield, and companies generating unit growth and solid levels of free cash flow.