Equities Appear More Attractive
than Other Asset Classes
September 19, 2016
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Global monetary policy experiences renewed focus as fears grow over a potential renewed tightening phase. In our view, monetary policy remains supportive of risk assets.
We believe U.S. and global economic growth should improve modestly over the coming year, which would be a positive for corporate earnings and equity prices.
U.S. equities experienced a volatile week, as monetary policy dominated the headlines. Dovish comments from Federal Reserve officials tamped down speculation that the central bank was on course to tighten aggressively. Investors are also closely watching any movement by the Bank of Japan to spark economic growth. Weaker economic growth data and rising U.S. political uncertainty were also factors last week. For the week, the S&P 500 Index gained 0.6%, as technology outperformed and financials and energy lagged.1
Weekly Top Themes
- The strong patch of summer U.S. economic data may have ended. Following weak Institute for Supply Management readings in previous weeks, August retail sales declined 0.3%.2 This marks the first pullback since March,2 and bears watching for a broader downtrend into September.
- The recent advance in bond yields may act as a headwind for equities. Sovereign yields have been advancing since July, but have only recently negatively affected equity markets. We don’t believe the increase will depress stock prices, but it may limit upside potential.
- Corporate earnings expectations are climbing slowly. Following a modest second quarter improvement, analyst expectations for future quarters have climbed in recent weeks.3 The largest increases are in the technology, health care and consumer discretionary sectors.3
- Equities may continue to climb in 2016, based on historical trends. Strategy group Fundstrat shows that since 1940, when stock prices increased more than 5% by mid-September, 87% of the time they rallied further in the last three-and-a-half months of the year.4 As of Friday’s close on September 16, the S&P 500 Index is up 6.3%.1
- Equity gains may be tough to come by, suggesting this remains a stock-picker’s market. In our view, the risk-reward trade-off for stocks is mediocre based on current valuations. Yet, equities remain relatively attractive with bonds appearing overvalued and cash returning close to zero. We believe selectivity will continue to be critical, making an implicit argument for active management.
Economic Growth and Policy Remain Equity Friendly
We believe global economic growth should continue improving modestly over the coming year. The United States will likely remain the primary growth engine, and it is reassuring that employment trends have remained solid despite many global headwinds. We believe income levels and consumer spending are likely to pick up in the coming quarters, which should help retail sales. Manufacturing has been uneven and global trade has struggled during this economic cycle, but we think employment and demand trends point to an eventual improvement in both areas. Outside of the U.S., the eurozone appears to have navigated the Brexit fallout without significant damage, while China’s economy has remained relatively resilient. This backdrop should be a positive for corporate earnings, and ultimately equity markets.
Global monetary policy has come into renewed focus in recent weeks. Some investors fear the world is entering a renewed tightening phase due to the European Central Bank’s decision not to expand its bond-buying program, confusion over Bank of Japan policy and the prospects for Fed rate hikes. In our view, worries are premature that the ECB and BOJ will not provide additional support. And even as the Fed considers raising rates, it remains focused on supporting economic growth and should do so slowly. Overall, monetary policy appears supportive of risk assets.
As such, we believe it makes sense to retain a mildly pro-growth, pro-risk investment stance. A number of risks exist, and the U.S. elections are currently in focus. The odds of a Clinton victory have fallen slightly in recent weeks. Prospects for a Trump victory have unsettled markets, given the uncertainty surrounding his economic policies. Investors are also worried about a sharper spike in bond yields. We would not ignore any of the risks, but still believe that equities appear more attractive than bonds or cash.
1 Source: Morningstar Direct, as of 9/16/16
2 Source: Commerce Department
3 Source: RBC Capital Markets
4 Source: Fundstrat
Last Week's Commentary
Monetary Policy Uncertainty
Disrupts Equity Markets
September 12, 2016
After six weeks of calm, equities dropped sharply on Friday in light of a spike in government bond yields and growing uncertainty over global monetary policy.
We believe equity markets should be able to withstand rising yields and remain attractive compared to bonds. As such, we favor an overweight position in stocks.
U.S. equities were relatively quiet last week before falling sharply on Friday, as
the S&P 500 Index declined 2.4% for the week.1 Global sovereign bond yields
also spiked on Friday.1 Selloffs in both asset classes were triggered by rising
uncertainty surrounding global monetary and fiscal policies. In other markets,
oil prices rebounded from a two-week decline due to falling inventory levels.1
Near-Term Downside Pressure May Persist
Equity markets were remarkably stable for most of the summer before Friday’s sharp
decline. The immediate cause appeared to be the European Central Bank’s decision
not to expand its bond-buying program, and a growing sense that the Federal
Reserve will raise rates this year. In our view, the selloff was magnified by high
leverage on the part of many hedge funds and professional money managers. When
volatility remains low, leverage tends to increase in the search for additional returns.
Downside shocks can be exacerbated by these positions. Given that confusion and
concern over central bank policies are likely to persist, and since there is probably
more leverage that needs to unwind, we would not be surprised to see some
additional near-term weakness in equity markets.
Weekly Top Themes
- Weak Institute for Supply Management readings in August renewed concerns over a growth slowdown. Both the ISM Manufacturing and Services Indices were worse-than-expected last month.2 We do believe overall economic growth will accelerate, but this is a negative trend with business confidence soft.
- Regardless of who wins the election in November, the odds of corporate tax reform surrounding repatriated earnings are growing. It is likely that any potential new tax revenue could be used to fund new infrastructure spending.
- The Fed appears on track to raise rates this year, despite a recent downtick in economic data. The odds of a September hike seem low; we think December is more likely.
- Given current inflation trends, the Fed may be falling behind the curve. Inflation is hardly a problem, but long-term trends show inflation accelerating modestly. Price levels are creeping up, and monthly jobs reports clearly show a slow increase in wages.
Equities Should Weather Higher Bond Yields
Even before Friday’s spike, global sovereign bond yields have been trending higher over the last six weeks. Yields have experienced upward pressure due to decent (albeit far from stellar) economic growth, modestly rising inflation, anticipation over Fed tightening, uncertainty about ECB and Bank of Japan policies and signals of forthcoming fiscal stimulus in the United States, United Kingdom, Germany, France and elsewhere.
This increase (and the potential for more) is undermining equity market sentiment.But we believe equities should remain resilient. First, from an economic perspective, we think yields are rising for good reasons. Specifically, improving global nominal growth appears to be driving the increase rather than a sharp adjustment in monetary policy or a lack of confidence in policymakers. Secondly, from a technical perspective, stock prices have been resilient in the face of climbing yields (at least before Friday’s selloff). Additionally, equities appear relatively cheap compared to the extremely low sovereign bond yields around the world.
As such, we maintain a reasonably constructive view toward both economic growth and equity markets. We expect the global economy will be marginally better than expected over the coming year and believe monetary policy will remain constructive for risk assets. The Fed is the lone major central bank on course to raise rates, but even a December increase represents a once-per-year increase pace, which is hardly restrictive. We will likely see ongoing occasional pockets of weakness in the equity markets, but we still believe it makes sense to overweight stocks and underweight government bonds.
1 Source: Morningstar Direct and Bloomberg, as of 9/9/16
2 Source: Institute for Supply Management