The Economy and Earnings
Should Strengthen Later This Year
May 2, 2016
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U.S. economic growth was weak during the first quarter, but should accelerate from here.
We expect the Fed to enact another rate increase at some point this summer.
Equity markets may be volatile over the coming months, but should rise once corporate earnings improve.
Equity markets fell last week, with the S&P 500 Index declining 1.2%.1 Monetary policy was in focus. The Federal Reserve meeting generated debate about the timing of the next rate hike and the Bank of Japan surprisingly failed to move rates even further into negative territory. Earnings were generally weak, while a fall in the value of the dollar led to another rally in commodity prices.1
Weekly Top Themes
First quarter economic growth was sluggish, but the economy should gain steam in the coming quarters. U.S. real gross domestic product advanced only 0.5% last quarter as the consumer sector remained steady, housing activity improved and capital expenditures were weak.2 Looking ahead, we expect both consumer spending and capex to improve, which should help the economy advance at a more moderate pace.
We expect the next Fed rate increase this summer. In its statement last week, the Fed indicated it is less concerned about global financial risks than it previously was, and also pointed to continued mixed economic performance. We think the central bank is focused on ongoing improvements in the labor market and is prepping investors for a probable rate hike in the coming months, provided economic data improve.
Earnings are likely to fall again for the first quarter. With 60% of S&P 500 companies reporting, earnings are slightly ahead of expectations (up 4%) while revenues are flat versus forecasts.3 Overall, earnings growth is set to decline by 4%, but would be up 1% ex-energy.3
Near-term dollar weakness may persist, but the dollar should strengthen later in the year. Despite recent weakness, investors still appear bullish on the dollar. Improving economic growth and the likelihood of higher interest rates should apply upward pressure.
Investors are viewing higher oil prices as a positive. The S&P 500 Index has risen close to 15% over the past couple of months and is now only a few percentage points away from its all-time high.1 The price increase has caused valuations to expand, which in our experience does not typically occur when commodity prices rise. This suggests that investors believe rising oil prices are removing some risk from the global financial system. In essence, investors are willing to accept higher energy costs for U.S. consumers if it means countries such as Russia face less economic pressures.
Equity Markets Appear Tired, but We Expect Improvements in the Coming Months
Risk assets have traded unevenly over the past couple of weeks as investors have reacted to a variety of crosscurrents, including relatively weak earnings, rising oil prices and mixed economic news. Investors are left to decide whether to double down on government bonds and other safe-haven assets, or trust that conditions are improving, and turn toward equities. Over the long-term, we think the latter course makes sense. Economic growth is improving. Earnings should accelerate. And inflation remains low. These are all long-term positives for stocks.
Monetary conditions are, admittedly, a wild card. At present, global monetary policy remains accommodative. The Fed is due to raise rates at some point, but even another rate hike (or two) would leave rates quite low relative to the condition of the economy. Additionally, corporate earnings are not currently strong enough to increase equity prices. Earnings forecasts are finally starting to turn positive, however, which is a strong sign considering economic growth has been so uneven.3
At this point, economic growth is not quite sufficient to entice investors to move out of safe-haven assets and take on more risk. And many are appropriately wary of the strong rally that has occurred over the past couple of months. Equities, high yield bonds and commodities may be overbought, and it would not be a surprise to see some sort of consolidation or pullback.
Over time, we expect a gradual improvement in global economic growth and a rebound in corporate earnings. These developments should be enough to allow for a climb in equity prices. As such, we expect equities to outperform bonds and cash over a six- to twelve-month time horizon.
1 Source: Morningstar Direct, as of 4/29/16
2 Source: Bureau of Economic Analysis
3 Source: RBC Capital Markets
Last Week's Commentary
Earnings Remain Key to
April 25, 2016
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