Equities Retreat, but Long-Term Prospects Should Improve
July 27, 2015
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Equities may be stuck in a trading range until uncertainties over Fed policy and global growth diminish.
Improving economic growth should allow corporate earnings to improve, helping stock prices to grind unevenly higher.
At the beginning of July, it became clear that Greece and European
policymakers would come to at least a temporary debt agreement. Since that
time, U.S. equity prices jumped, with the S&P 500 Index climbing more than
4% by the beginning of last week.1 That trend reversed last week, however,
and the S&P lost about half of those gains, falling 2.2%.1 Some of the pullback
can be blamed on the usual suspects — concerns over economic growth
and corporate earnings, as well as worries over a pending shift in Fed policy.
We would also argue that market technicals are starting to look uneven,
suggesting equities may be due for a period of consolidation.
Weekly Top Themes
- Corporate earnings have been mixed, but more positive than negative trends
have emerged. To date, 35% of S&P 500 companies have reported second-quarter
earnings.2 The good news is that earnings are beating expectations by
5.8%, which is above the average pace since the end of the Great Recession.2
Revenues, however, remain stuck in neutral, and are only exceeding expectations
by 0.3%.2 The industrials sector has been hit by lower energy prices and slowing
growth in China and has been trailing the rest of the pack.
- Evidence continues to point to improvements in the jobs market. The latest
weekly jobless claims reading shows the number dropped to 255,000.3 This marks
the lowest level since 1973.3
- We are not expecting significant news to come from this week’s Federal
Reserve policy meeting. The Fed will probably reiterate there is ongoing
progress in economic growth and suggest interest rate increases remain on the
horizon. We don’t think the Fed will provide a specific timeframe, but September
still seems to be the most likely starting point for the Fed’s first rate hike.
- Issues in Greece and China have faded from the headlines, but structural
problems remain. While investors may no longer be focused on the day-to-day
drama, at some point these concerns may well resurface.
- Market technicals appear stretched. In our view, signs such as the advance/
decline line and upside/downside volume have started to trend in a negative
direction over the past few weeks. This may mean nothing, but our experience
suggests it may also mean that equities are due for a period of consolidation that
may last several weeks or longer.
When Uncertainty Fades, the Outlook Should Brighten
There are a number of issues causing investor unease to remain high. Questions over
Fed policy, concerns over whether issues in China and Greece will lead to broader
contagion and worries about the recent downshift in energy and commodity prices
top the list. The last six months have been bumpy for equities, but we believe the
landscape should improve over the next year, helping equities to outperform bonds
The trend of a rising dollar/falling oil dominated the investment landscape at the
end of last year before fading in the spring. But more recently, we have a witnessed a
return of these issues and the recent firming of the dollar and downtick in oil prices
have caused some renewed concerns. Some of the moves have to do with easing
geopolitical issues (such as signs of progress in negotiations with Iran) as well as
slowing growth in China. But long-term structural issues should also keep upward
pressure on the dollar and downward pressure on oil prices. The good news is that
unlike what happened last year, recent moves have not triggered deflationary fears
and massive downward moves in global government bond yields.
Looking ahead, we expect equity prices will be driven by a better corporate earnings
environment and upward movement in U.S. interest rates. Rising rates have the
potential to be disruptive in the near term for equities, but should the rate increase
occur in an orderly manner, we think it will be perceived as an acknowledgement of
improved economic conditions. This should provide a solid backdrop for earnings.
Equities may not be particularly inexpensive compared to their own history, but we
think they appear attractive relative to bonds and cash. And although markets may
churn until the outlook becomes more clear, we remain cautiously optimistic toward
1 Source: Morningstar Direct, as of 7/24/15
2 Source: RBC Capital Markets
3 Source: Labor Department
Last Week's Commentary
Equities Rise as the Focus Returns to Fundamentals
July 20, 2015
Risks in Greece and China receded, which allowed investors to focus on the prospects for better economic growth and improving corporate earnings.
Global risks have not vanished, but assuming corporate earnings can rise, equity prices should be able to advance.
U.S. equities experienced their largest one-week gain since late March last
week, with the S&P 500 Index rising 2.4%.1 Much of the gain came from an
easing of Greece’s debt problems and a calming of volatility in China’s equity
market. In both cases, policymakers achieved some breathing room, but
fundamental issues remain. Greece must still engage in some serious structural
reforms and the Chinese economy is still experiencing a significant slowdown.
In addition to easing global tensions, U.S. equities were buoyed by positive
earnings surprises that came against lowered expectations. On the negative
side, June retail sales disappointed. The technology and financial sectors were
the best performing areas of the market last week, while energy and materials
struggled.1 In other markets, Treasuries were mixed as the yield curve flattened,
while commodity prices experienced a pullback.1
Weekly Top Themes
Weak retail sales figures show the consumer sector is still not firing on all
cylinders. Sales unexpectedly fell 0.3% in June,2 although we expect to see a
rebound in the data going forward. Solid levels of jobs growth and still-low
energy prices and interest rates should provide tailwinds for consumer spending.
A rise in industrial production shows the negative effects from weakness in oil
prices may be fading. Plummeting oil prices in late 2014 resulted a sharp decline
in energy-related production that persisted through the first half of 2015. In
June, however, industrial production rose 0.3%, suggesting this negative economic
trend may be ending.3
We are seeing early signs of upward pressure on wages. We think it is inevitable
that continued jobs growth and falling unemployment will raise wage pressures.
And based on our conversations with corporate management teams, many
companies are ramping up hiring plans at the same time that demand for high-skilled
labor is growing.
Signs point to Federal Reserve rate hikes starting this year. We believe
the U.S. economy is accelerating. Improvements in the housing market and
manufacturing are good signs, and we expect to see a rebound in consumer
spending. In her testimony to Congress last week, Fed Chair Janet Yellen stated,
"If the economy evolves as we expect, economic conditions likely would make it
appropriate at some point this year to raise the federal funds rate target, thereby
beginning to normalize the stance of monetary policy."3 Our best guess for
timing is September.
Global monetary policy should remain highly accommodative for some time.
When the Fed does begin to raise rates, we expect it will do so slowly. And even
with a handful of rate increases, interest rates in the United States will still be
very low by historic standards. Outside of the United States, many central banks
are still in the midst of easing cycles. In all, monetary policy around the world
should provide a boost to global economic growth.
A Corporate Earnings Rebound Should Lift Equities
Over the past few weeks, financial markets endured some serious risks, with the
focus centered on Greece and China. Yet global equity prices remained resilient,
which suggests that the years-long bull market still has legs. At the same time,
global government bond yields held relatively steady rather than retreating, which
may be a sign that investors are expecting global economic growth to push ahead.
Encouragingly, these risks appear to be receding for now. The Greek government has
given in to austerity demands, the Chinese government has stemmed the equity selloff
and the nuclear deal with Iran may ease tensions in the Middle East.
At some point, one of these issues will resurface or another issue will emerge
that could spark more investor unease. But for now, investors appear focused
on fundamental improvements in the economy and the prospects for corporate
earnings. U.S. economic data remains choppy, but points to broad improvements.
And we think the prospects for corporate earnings are brightening. At this point,
analysts are projecting U.S. corporate earnings will grow a paltry 1% for 2015.4
In our view, these expectations are too pessimistic. Assuming economic growth
improves as we expect, we should see stronger earnings results. This should allow
equity prices more room to rise.
1 Source: Morningstar Direct and Bloomberg, as of 7/17/15
2 Source: Department of Commerce
3 Source: Federal Reserve
4 Source: FactSet