Investors Await Election
and Fed Rate Outcomes
October 24, 2016
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Third-quarter earnings started strong. Should this persist, it may mark the end of the earnings recession.
It looks likely that Hillary Clinton will win the presidency while the House remains in GOP hands.
Equity markets face near-term pressures, but the economic and earnings environment should provide tailwinds.
U.S. equities moved slightly higher last week, with the S&P 500 Index climbing 0.4%.1 Corporate earnings results were solid, while data showed economic stabilization in China. Investors also reacted positively to high-profile merger-and-acquisition news. For the week, the materials, financials, consumer discretionary and technology sectors advanced while telecommunications, industrials and consumer staples lagged.1
Weekly Top Themes
- Third quarter earnings results have been surprisingly strong. With more than 25% of S&P 500 companies reporting, earnings are beating expectations by 7% and revenues by 1%.2 Should these patterns hold, it will mark the end of the earnings recession largely caused by the rising dollar/falling oil trends.
- Investors appear overly complacent about inflation. Economic growth is accelerating modestly, major central banks are becoming less accommodative and government spending is rising. These trends suggest we should see an uptick in inflation. A continued increase could put more pressure on the Federal Reserve and act as a headwind for bonds and equity valuations.
- Defensive, yield-oriented equity sectors appear unattractive. Sectors such as utilities and telecommunications sharply underperformed in the third quarter as bond yields started to rise.1 We think these sort of bond-market proxies continue to look expensive and expect a continued shift toward economically sensitive cyclical sectors.
- Infrastructure spending will likely increase in 2017. It appears increasingly likely that Hillary Clinton will be elected president, and we think she will soon focus on a fiscal stimulus plan that emphasizes infrastructure. Republicans in Congress may support this effort, especially if it is packaged with corporate tax reform centered on repatriated earnings.
- Rising bond yields may limit prospects for a year-end equity rally. We do not expect a notable drop in prices over the next couple of months, but we believe any significant upside might be limited.
Interest Rates and Bond Yields May Advance Modestly
The presidential debates are over and election season is hitting the home stretch. Barring a massive shock, we think Hillary Clinton will likely be elected president, while the House remains in Republican hands. The Senate appears up for grabs. This environment would represent a more-or-less continuation of the status quo. Such a political backdrop would likely allow the economy to maintain momentum and the Fed to slowly raise rates. In the financial markets, this would represent a modest headwind for bonds and a tailwind for the U.S. dollar. If the Democratic party’s momentum accelerates and results in a complete change of control over Congress, this could raise uncertainty and create a more difficult environment for the economy and markets.
Investors are also closely watching the Fed. We think the Fed will very likely raise rates for the second time this cycle in December. The Fed will likely remain cautious into 2017, but it could become slightly more aggressive if and when inflation begins clearly accelerating. While many parts of the world still deal with deflationary pressures, that is not the case in the United States. The longer the economy stays on track and generates employment gains and rising wages, additional rate increases will become inevitable.
For equities, there is a growing sense among many investors that valuations are becoming expensive and stocks might be due for a correction. We think rising yields could pressure equity prices, but we do not expect a prolonged or sharp equity market decline. Economic pessimism is high and investors maintain high levels of cash. This does not indicate a peak in equity prices. Likewise, technical indicators do not signal a near-term end to the bull market (for example, high yield spreads are continuing to fall).1 We think equities may be mildly overbought following the uptrend since the post-Brexit selloff. We could see a near-term pause or mild correction, but an improving economy and brightening earnings and profits are solid long-term signals for stocks.
1 Source: Morningstar Direct and Bloomberg, as of 10/21/16
2 Source: RBC Capital Markets
Last Week's Commentary
If Earnings Turn Positive,
Equities Should Follow
October 17, 2016
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Third quarter earnings started off poorly, dragging down equity market sentiment.
We expect earnings results to improve over the coming quarters, which should act as a tailwind for equities.
Investors face a number of risks, but we advocate a cautiously pro-growth investment stance.
U.S. equities retreated last week, with the S&P 500 Index declining 1.0%.1 Sentiment was dragged down by negative earnings updates, a disappointing trade report from China and rising U.S. political turmoil. For the week, defensive and yield-generating sectors outperformed, while materials and health care lagged.1
Weekly Top Themes
- Equities may struggle until corporate earnings improve. For the past 18 months, equities have been able to make modest gains despite declining corporate profits. This has largely been due to highly accommodative monetary policy and central banks’ willingness to engage in new easing measures. Additionally, investors have been willing to look past the earnings recession since we have not seen a corresponding economic recession. Looking ahead, we believe earnings must advance for equity markets to make meaningful gains. It is early in the third quarter reporting season, but so far the news hasn’t been favorable.
- It may take another quarter before corporate earnings accelerate. At present, consensus expectations are that earnings will decline 3% in the third quarter while revenues rise 3%.2 Excluding energy, earnings would be up 1% with revenues advancing 4%.2 Conditions should improve in the fourth quarter, with consensus expectations pointing to a 6% earnings increase.2
- The minutes from the September Federal Reserve meeting indicate a December rate increase is likely. The minutes also showed that the decision not to raise rates last month was a close call.
- The U.S. economy is unlikely to sink into recession, but remains vulnerable. With nominal gross domestic product growth so low (it has been averaging around 3% this year),3 the economy could falter if we see a sharp oil price increase, a spike in bond yields, escalating political uncertainty or other shocks.
- Equity markets may react more positively to divided government. At this juncture, it looks likely that Hillary Clinton will be elected president. The Senate appears up for grabs, which makes the House of Representatives key. We expect the House to remain in GOP hands, but if Democrats take control we would likely see a minimum wage increase, tax increases and further regulations in the health care and financial services industries. Such events would likely trigger additional economic and market uncertainty.
Despite Many Positives, Anxiety Remain High
While investors have focused on an increasingly contentious U.S. political backdrop, the global economy has been reasonably solid. Brexit spillover has not affected the rest of Europe, Chinese growth has remained relatively stable and the United States has been slowly accelerating.
Despite a reasonably decent backdrop, investors have been cautious and unwilling to take on more risk in their portfolios in recent years. This wariness is understandable given the high number of shocks occurring in this cycle, including the sharp collapse in commodity prices, the Greek debt crisis, China devaluing its currency, Brexit, widespread terrorism, geopolitical uncertainty and a fractious U.S. political backdrop.
As a result, stock prices have been trapped in a relatively volatile trading range, moving only slightly higher since the beginning of 2015. Looking ahead, we think the macro backdrop should be conducive for better equity performance. Global growth remains solid and corporate earnings should recover in the coming quarters.
For these trends to translate into firmer equity prices, investors must believe the global economic recovery and earnings cycles will become self-sustaining, meaning that equities will no longer be dependent on monetary policy stimulus. While we remain cognizant of all of these risks, we nevertheless advocate retaining a pro-growth but cautious investment stance.
1 Source: Morningstar Direct, as of 10/14/16
2 Source: Bernstein Research
3 Source: Bureau of Economic Analysis