Equities May Struggle, but Should
Outperform Other Asset Classes
June 20, 2016
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Corporate earnings remain the key for equity prices. If earnings and profits improve over the coming months, equities should break out to the upside.
The Brexit vote and the U.S. elections are causing an unusual amount of political uncertainty, but shouldn’t derail the markets.
Last week started on a horrific note with the massacre in Orlando. That event and growing anxiety over the possible U.K. exit from the European Union (the Brexit) dragged down investor sentiment. The S&P 500 Index fell 1.1% last week.1 Financials came under pressure, while the more defensive telecom and utilities sectors bucked the broader trend and gained ground. Non-U.S. stocks fared even worse, with European markets declining around 2% and Japanese stocks dropping over 3%.1
Weekly Top Themes
A Federal Reserve rate hike in July is unlikely. The decision to keep rates on hold came as no surprise, as the Fed pointed to recent labor market weakness and escalating global risks. If the June jobs report shows a strong rebound and the Brexit risk is avoided, the odds of a rate hike next month would rise.
The solid retail sales report from May should allay fears of a weakening economy. Sales rose 0.5% last month,2 which should provide some comfort to those who feared May’s weak jobs report was the start of a broader economic downturn. We believe that real gross domestic product may grow by as much as 3% in the second quarter.
The manufacturing sector, however, continues to struggle. The latest data from May shows industrial production fell 0.4%.3
Inflation continues to rise slowly. The headline consumer price index increased by a modest 1.0% annual rate in May.4 However, core inflation ticked up to 2.2%, the seventh consecutive month in which core inflation rose by 2% or more.4 We expect firmer commodities prices and the fading strength of the dollar should push inflation modestly higher over the coming months.
Still-low rates are a positive for equities, but earnings remain the key variable. Investors were cheered last week by indications that the Fed is in no hurry to raise interest rates. Looking ahead, we think the key factor that will drive equity prices is whether corporate earnings and profits can improve over the second half of 2016 and into 2017.
Global deflationary forces have faded, but have not vanished. Early in the year, weak commodity prices and worries over Chinese growth were triggering widespread deflation concerns. Deflation risks have receded, but remain. A steepening in global yield curves would be a key signal that deflation risks are finally in the rearview mirror.
Prospects for equities are mixed, but appear stronger than other asset classes. After appreciating significantly since 2009, equities are not as cheap as they used to be, but we believe they are also not in bubble territory. We think gains will be tough to come by in a slow-growth world, but we still think equities will outperform bonds and cash over the next six to twelve months. As such, we think investors should retain a pro-growth investment bias.
U.K. and U.S. Politics Are Causing Near-Term Uncertainty
The most pressing political risk is the Brexit threat. We think the odds favor the June 23 referendum not passing, keeping the U.K. in the European Union. But there is a real chance that the U.K. will choose to leave. The uncertainty has undermined economic confidence and has been a headwind for global stock markets. Should the Brexit happen, we think it would be a serious misstep that could not be easily remedied. We believe it would cause the U.K. economy to shrink and could spark housing and credit crises. A Brexit could also morph into a more widespread global financial problem as it drags down global trade levels.
The next political issue on the horizon is the uncertainty surrounding the U.S. elections. Whether or not investors like Hillary Clinton, her economic policies are clear and transparent, and come with a measure of certainty. The same cannot be said about Donald Trump, since his views are inconsistent and lacking specificity (at least as of now, and he does have five months to amplify and clarify his proposals). His most clearly articulated views indicate he may trigger trade wars, which would likely be negatives for the U.S. and global economies. From those perspectives, at least, we think equity markets would currently favor a Clinton victory.
1Morningstar Direct, and Bloomberg as of 6/17/16
2Source: Commerce Department
3Source: Federal Reserve
4Source: Labor Department
Last Week's Commentary
The Intermediate Outlook Is
Brighter Than the Near-Term
June 13, 2016
Investor sentiment remains uneven, but we believe the fundamental backdrop is stronger than many believe.
Financial markets have proven to be resilient to negative economic news and a number of near-term global risks. We think that is positive for equity prices.
Equity markets were mixed last week, rising in the first half of the week before declining. Signs of stabilization in China and a lower likelihood of near-term Federal Reserve tightening helped markets, while economic growth worries, the upcoming referendum in England to determine whether to remain a part of the European Union (the “Brexit” vote) and falling bond yields weighed on stocks. For the week, the S&P 500 Index declined a modest 0.1%.1
Investor Sentiment Remains Mixed at Best
As usual, the bulls and bears have different outlooks. The bulls point to cautious sentiment, reasonable valuations, relatively stable growth conditions and prospects for better earnings results as reasons to be positive toward equities. The bears, in contrast, believe earning are unlikely to improve (meaning valuations are stretched), and focus on unresolved big-picture risks such as Chinese growth, Brexit and the uncertain U.S. elections. In our view, fundamentals lie somewhere in between. We agree there are reasons to worry, but think the fundamental backdrop is stronger than the bears believe.
Weekly Top Themes
The weak May employment report continues to weigh on sentiment, but should be kept in perspective. Last month’s jobs report is hardly the first time a monthly reading has disappointed. In fact, May marks the sixth time in the last five years we have seen a disappointment of this approximate magnitude.2 The jobs data does not call into question the overall health of the economy, but does increase uncertainty over Fed policy.
The nature of the labor market is shifting. As the current economic expansion matures and as the U.S. approaches full employment, it is no surprise that the pace of jobs growth is slowing. Wages have been rising, which should help consumer spending remain solid. We also expect productivity levels to improve, which should boost both wages and corporate profits.
Corporate earnings should experience uneven improvement. We believe we are past the worst of the drags from the oil rout/soaring dollar. Earnings should trend higher, but the path will remain rocky.
Corporate buybacks and other shareholder-friendly activities should be a plus for equity prices. S&P 500 companies repurchased $165 billion worth of stock in the first quarter, the strongest pace since the third quarter of 2007 and the second-highest level in history.3 With corporate cash levels high, we expect buybacks and dividend increases will continue.
Non-U.S. equities have lagged their domestic counterparts. Although U.S. markets are approaching their all-time highs, other regions remain far from that milestone. U.K. stocks are 11% below their all-time highs, while Germany is off 17% and China and Japan lag by more than 50%.4
Financial Markets Are Starting to Show Resilience
Over the last several weeks, we have continued to see mixed economic news and flare-ups in global risks, but markets appear to be showing tentative signs of resilience. The latest worries include the downturn in the U.S. labor market, the upcoming U.K. referendum and uncertainty over Fed policy.
Despite these concerns, stock prices have not sold off and the U.S. dollar has remained resilient in the face of negative economic news and lowered rate increase expectations. While Treasury yields resumed their downturn, the pace has not been as sharp as might have been expected, especially given the sharp decline by German government bond yields into negative territory. Oil prices have been rising due to supply disruptions, but we expect oil to remain range-bound, since drilling and output have the capacity to increase if prices continue to rise.
We believe all of these trends are long-term positives for the equity markets. Investors need to weather a number of near-term risks, and we think caution is warranted considering how far stock prices have risen since mid-February. The medium- and long-term outlook for equities remains bright, however, especially if we see improvements in U.S. consumer spending, global manufacturing and corporate earnings.
1Source: Morningstar Direct, as of 6/10/16
2Source: Cornerstone Macro
3Source: Goldman Sachs
4Source: Bloomberg and Morningstar Direct