Earnings Remain Key to
April 25, 2016
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Equities rallied again last week and are near the top of their current trading range.
Earnings and global economic growth are mixed, but should improve as 2016 progresses.
Should this growth occur, we expect equities will break out to the upside, with leadership shifting toward non-U.S. stocks.
Equities climbed yet again last week, with the S&P 500 Index rising 0.5%.1 Corporate earnings were mixed, and the biggest market story was ongoing strength in commodities, particularly oil and metals. Bank stocks rallied strongly for a second week, while defensive market segments struggled to keep pace.1
Weekly Top Themes
Energy continues to weigh on corporate earnings. With one-quarter of S&P 500 companies reporting, earnings are beating expectations by 3.5% and revenues are showing upside surprises of 0.5%.2 Overall earnings-per-share growth projects to be down 5.0% for the quarter, but ex-energy would be up 1.0%.2
The first quarter looks to be the fifteenth in a row where U.S. domestically-oriented corporate earnings lead the way. This market segment should experience earnings declines of around 3%, while internationally-focused U.S. company earnings are on track to decline 14%.2
Economic growth should accelerate after a weak first quarter. First quarter gross domestic product growth data will be released on Thursday. We expect it will show the economy grew by 1% at best. Growth should bounce back in the second quarter, led by improvements in consumer spending and manufacturing.
The Federal Reserve will likely increase rates two times in 2016. For the past several years, the Fed has successfully stimulated economic growth and helped stave off deflationary pressures. At this point, we believe the economy is accelerating and inflation is slowly rising. As a result, we think the Fed will likely continue a slow and gradual pace of rate increases.
The current trend of U.S. dollar weakness should fade. The recent drop in the value of the dollar is due to dovish comments by Fed officials and strengthening commodity-oriented emerging market currencies. Both factors should diminish as we approach the next Fed rate increase and as commodity prices stabilize into a less volatile trading range.
Equities Should Outperform Over the Long Term
Equities and other risk assets (most notably high yield bonds) have rallied nicely over the past couple of months.1 In hindsight, it seems investors were overly pessimistic about the possibility of a recession and overstated the risks of plunging oil prices earlier this year. Economic data is choppy, but we believe the U.S. economy is clearly accelerating. And it also appears evident that the decline in oil prices was due more to a supply glut than falling demand.
The current rally appears to be powered by two primary factors: stabilizing Chinese growth and a more dovish turn by the Fed. Clarity from China has boosted oil prices and eased concerns about currency devaluation. And a less hawkish Fed decreased the value of the dollar and kept bond yields low, even as stock prices rallied. The longevity of both of these factors needs to be questioned, however. The Chinese economy is still slowing and could continue to act as a deflationary force on the global economy. And we think the Fed is still in a rate-hiking mode. This could potentially disrupt the equity rally, especially as we approach the next increase, which we think will happen this summer.
So where does that leave equities? Stock prices are near the top of their recent trading range, and we think corporate earnings improvements and stronger global economic growth are necessary for equities to break out to the upside. We expect both catalysts will materialize, but probably not until later this year. At the same time, stronger economic growth and rising inflation will put upward pressure on government bond yields. We believe there is a disconnect between current low yields and the reality of the economic and inflation picture. This makes Treasuries and other government bonds vulnerable.
As a result, we think equities are poised to outperform bonds over the coming year. So far in 2016, U.S. equities have outperformed most other markets. We anticipate market leadership should rotate away from U.S. stocks sometime this year, but probably not until confidence in the global economy rises.
1 Source: Morningstar Direct, as of 4/22/16
2 Source: RBC Capital Markets
Last Week's Commentary
Expect Economic and Market
Improvements Later in 2016
April 18, 2016
U.S. economic growth is slow, but may accelerate in the coming quarters.
The key variable for equity markets remains corporate earnings. We expect better results in the second half of 2016.
Investor sentiment should improve as well, reinforcing our pro-growth investment view.
The uneven market uptrend in place since mid-February resumed last week, with the S&P 500 Index climbing 1.7%.1 The primary catalyst appeared to be better-than-expected corporate earnings results in the still-early reporting season, particularly from the banking sector. As a result, bank stocks performed particularly well, rising 7% last week, marking the best weekly gain in over four years.1 Investors also focused on better economic data coming from China and ongoing evidence that the U.S. economy is growing slowly.
Weekly Top Themes
U.S. economic growth should rebound after a weak first quarter. We think first quarter real gross domestic product will likely have advanced by less than 1%. A deteriorating trade balance, declining inventories and falling automobile sales all point to an economy that is growing only modestly. Looking ahead, indicators such as the latest beige book reading from the Federal Reserve (which showed a pickup in wages, consumer spending and hiring) suggest growth should accelerate in the coming quarters.2
Manufacturing data remain mixed, but should also improve. Following positive results from the previous weeks, March industrial production numbers ended worse than anticipated.2 It appears that the effects of the stronger dollar and anemic global trade remain headwinds, but we believe these drags are beginning to fade.
Likewise, consumer spending should accelerate. Consistent with other economic readings, March retail sales figures were disappointing.3 But the strong jobs market and rising wages suggest consumer spending levels could be also poised for an uptrend.
Improving economic growth should help corporate earnings. S&P 500 earnings have been flat to negative for the past five quarters.4 This largely explains why equity prices have remained static over that time period. We think broader economic acceleration should help earnings to recover in the second half of 2016. This should be a positive for stock prices.
Rising labor costs are a potential risk. Slow wage growth has been a plus for corporate earnings over the past year. But wages are finally rising, which presents some negatives. Growth in average hourly earnings is approaching its fastest pace in five years,5 and declining unemployment levels should continue exerting upward pressure on wages. This is a positive for consumer spending, but complicates the corporate earnings outlook.
Long-Term Conditions Favor Equities
We have witnessed two double-digit equity market declines and subsequent rebounds since last summer. In both cases, the initial sell-off was mainly due to concerns over global economic growth (first in China and secondly in the United States). Over the past couple of months, conditions appear to have stabilized, and risk assets have held up moderately well. Signs of economic and policy clarity from China have helped, as have renewed commitments toward pro-growth policies from global central banks.
At this juncture, we believe the economic backdrop and relative valuations favor equities over bonds and fixed income credit sectors over government-related areas. The keys toward whether our view is correct will probably be ongoing improvements in the global economy and an increase in investors’ risk appetite. We are fairly confident that the former condition will materialize, but the latter is less certain. Sentiment is better today than it was a couple of months ago, but remains tilted toward the bearish view.
Nevertheless, we continue to have a modest pro-growth investment view. Over the near-term, additional market turbulence is likely, particularly since equity prices have risen so far, so quickly. The prospects for an additional Fed rate hike this summer could unnerve investors. We expect more economic and earnings clarity later in the year, which should allow for greater stability in the markets.
1 Source: Morningstar Direct, as of 4/15/16
2 Source: Federal Reserve
3 Source: Commerce Department
4 Source: Citi Research
5 Source: Goldman Sachs