Equities Push Ahead Despite Softening Economic Growth
May 18, 2015
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U.S. economic growth remains slow, but we believe the overall state of the global economy remains solid.
Although rising yields and a pending shift in Fed policy may contribute to higher equity market volatility, we continue to advocate a pro-growth investment stance.
The continued advance in global bond yields dominated the financial story
again last week, although this trend eased slightly by the end of the week.
Economic data featured a relatively weak retail sales report. Notwithstanding
these factors, U.S. equities advanced, with the S&P 500 Index hitting another
record high as it gained 0.4%.1 The consumer staples, health care, industrials
and technology sectors led the way, while energy was the worst-performing
area of the market.1
Weekly Top Themes
- Retail sales figures are not climbing as anticipated. Despite solid employment
gains, retail sales were flat for April, suggesting that consumers are continuing to
save rather than spend.2 We expect spending levels to rise in the coming months,
but the consumer sector is not currently helping growth as much as many
- U.S. economic growth is not yet accelerating. Following a weak first quarter,
most economic data suggest that the second quarter has not yet picked up
noticeably. We would not be surprised to see first quarter gross domestic product
growth revised lower. While the second quarter should be better than the first,
those numbers may also be disappointing.
- It will be difficult for the "Goldilocks" investing backdrop to persist. For the
past six years, investors enjoyed an economic backdrop strong enough to push
most asset classes higher but not so strong that inflation or tightening monetary
policy emerged as threats. With uneven economic growth and emerging signs of
wage inflation, we believe the investing environment is becoming more difficult
and that selectivity is growing in importance.
- Global growth prospects appear mixed. We expect Europe to become a stronger
tailwind for the world economy thanks to low commodity prices, a cheaper euro
and an accommodative central bank. In contrast, it looks to us like Chinese
growth will continue to decelerate.
- Overall, we believe the global economy will improve in the coming months.
The "stronger dollar/weaker commodities" trade that emerged in the middle of
last year indicated investors were expecting global growth to be soft as deflation
fears were rising. We have begun to see the strength of that trade diminish with
deflation risks fading and growth prospects improving.
Investor Confidence Should Pick Up in the Coming Months
Concerns over deflation are fading as it becomes increasingly clear that global
growth is recovering. Economic conditions around the world and in the United
States remain uneven, but we still believe that Federal Reserve rate hikes are
inevitable. As we approach the first rate increases, investor anxiety will likely increase
as worries mount that the Fed will become too aggressive and act in a manner that is
detrimental to economic growth. It may seem odd that this would become a concern
considering how dovish the Fed has been and how much central bankers have
focused on transparency. But the 2013 "taper tantrum" taught us that investors are
prone to overreaction and that once yields start rising, many will become concerned
about the possibility of deflation and economic stagnation.
Because of these concerns, one of the prominent near-term risks for equities is that
bond yields will advance too quickly, which could trip up the stock market. We think
such a scenario is unlikely. Improving global growth and a pending shift in Federal
Reserve policy will put upward pressure on bond yields. But many regions of the
world are still in an easing cycle, which should prevent yields from advancing too
dramatically. For its part, the Fed should proceed cautiously so as not to risk slowing
U.S. growth. Once the Fed starts to act, we believe investor confidence will rise. As
such, we expect any setbacks in equities that result from rising rates to be temporary.
Likewise, we believe the dramatic volatility in currency and commodity markets is
starting to fade. These markets remain unsettled and may continue to be choppy for
some time, but should calm somewhat. Increased stability should provide a further
boost to investor confidence. Overall, we acknowledge clear risks to the global
economy, but we continue to advocate a pro-growth investment stance and favor
overweight positions for equities.
1 Source: Morningstar Direct, as of 6/20/14
2 Source: Department of Commerce
Last Week's Commentary
Roadblocks to Equity Gains May Start to Fade
May 11, 2015
U.S. and global economic growth should improve in the coming months, but areas of the world are still in need of policy support.
The advance in global bond yields should persist, but rates will likely move slowly and unevenly higher.
These factors suggest tailwinds for the equity market may strengthen later this year.
Investors had a lot to react to last week, with the biggest story being a
continued rise in global bond yields. The Conservative Party secured an
unexpectedly decisive victory in the U.K. elections and Fed Chair Janet Yellen
commented about higher equity valuations. Chinese equities experienced
their largest weekly sell-off in five years following an impressive eight-week
winning streak.1 In the U.S., the S&P 500 Index gained 0.4% thanks to a strong
rally on Friday following the release of April’s jobs data.1 Financials and health
care were the best-performing sectors, while telecom and energy lagged.1
Weekly Top Themes
- The labor market appears to have moved from "great" to "good." The April jobs
report showed 223,000 new jobs were created as the unemployment rate ticked
down to 5.4%,2 solid numbers that were in line with expectations. Beneath the
surface, there were signs of some softness, as average hourly earnings increased
by only 0.1%, and the average work week was unchanged.2 All told, the report
shouldn’t change expectations for Fed rate hikes.
- Earnings are beating expectations, but overall growth is modest at best. Over
90% of S&P 500 companies have reported results, and earnings are ahead of
expectations by about 7%, while revenues are in line.3 By the time the dust settles,
current trends suggest first quarter revenue growth will be down 3%, earnings
will be up 1% and earnings-per-share will be up 3%.3 Were it not for the energy
sector, earnings growth would likely have advanced in the double-digit range.3
- Wage growth is accelerating. The Employment Cost Index, perhaps the best
measure of wage inflation, has climbed by its fastest pace in six years.2 Over the
past year, the overall Index has accelerated from 1.8% to 2.6%, with wages rising
2.5% and benefits 2.7%.2
- The long-term "dollar up/commodities down" trend will likely resume. This
trend may have reached an extreme position earlier this year, and we have seen
a reversal in recent weeks. While this reversal may have further to run, we have
a long-term bullish view toward the dollar and believe commodities will remain
- The macro backdrop still appears equity-friendly. First-quarter growth was
weak, but we expect to see a rebound. The Fed is gearing up for rate increases
(likely at some point in the fall), but such a shift is unlikely to be dramatic
enough to cause long-term issues for equities. Corporate earnings are hardly
robust, but have been better than feared. We expect conditions will improve in
the coming months, which should allow for further advances in stock prices.
Equities Should Withstand Rising Global Bond Yields
U.S. equities fared relatively well in the first quarter despite softening growth.
However, a different factor now threatens to disrupt the bull market: rising bond
yields. Since economic sentiment has not yet fully recovered, the threat of higher
rates is prompting some additional equity market volatility. U.S. Treasury yields
fell earlier in the year in the face of weaker growth, but have since rebounded and
are close to the same level where they began 2015.1 Outside of the United States,
Europe is still recovering, although the pace may be tapering off. Japan is still
struggling and requires a revival in global trade. And Chinese growth continues
to slow. In all, we view the global economy as improving but still in need of policy
support in many areas.
The good news for equities is that both U.S. and global growth appear to be
improving. We expect government bond yields to rise in the coming months,
however, which will put this area of the market under pressure. A combination of
higher inflation expectations, solidifying global growth and a shift in Fed policy is
likely to drive yields higher.
If bond yields were to rise quickly and dramatically, it could trigger an equity market
correction. Given ample liquidity and still-easy global monetary policy, however,
we are expecting a more benign bond yield advance. As such, we expect to see
additional turbulence in equities when the Fed raises rates, but we believe this bull
market still has room to grow.
1 Source: Morningstar Direct, and Bloomberg as of 5/8/15
2 Source: Bureau of Labor Statistics
3 Source: RBC Capital Markets