Drags on the Economy and Earnings Should Slowly Fade
April 20, 2015
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- Corporate earnings have been held back by
falling oil prices and the stronger U.S. dollar.
These headwinds should diminish by the
second half of 2015.
- Despite a preponderance of negatives,
we believe the global economy is slowly
improving, which should help equities post
Investors focused on the negatives last week, including some disappointing
U.S. economic data and growing concerns over what will happen with
Greece’s debt problems. U.S. equities fell, with most of the damage coming on
Friday amid a global risk-off trade.1 The S&P 500 Index declined 1.0%, with the
industrials sector leading the way downward.1 In contrast, energy performed
the best, helped by a rally in oil prices.1 Outside of the United States, Chinese
stocks continued to soar,1 as weak economic data sparked expectations for
additional policy support. Over the weekend, these expectations came to
fruition when the People’s Bank of China announced a cut in bank reserve
requirements, a move designed to boost lending.
Weekly Top Themes
- Earnings expectations look weak, but we expect a rebound later this year.
Standard & Poor’s is currently forecasting 2015 earnings for the S&P 500 to
increase by a mere 0.2%.2 Most of this weakness is concentrated in the energy
sector, and excluding energy, the growth rate would be 7.5%.2 Oil prices and the
U.S. dollar both appear to be stabilizing, which we believe should help earnings
outperform expectations in the second half of 2015.
- The beneficial effects of lower oil prices have yet to be realized. In our opinion,
the drop in oil prices happened so quickly that the results have yet to work their
way through the economy. Even if prices don’t drop further and stay close to their
relatively low levels, we think we could still see downward pressure on gasoline
prices. Additionally, we expect to see consumer spending rise over the coming
- We continue to have a bullish long-term view toward the dollar. Given the
enormous increase since last summer, however, a period of consolidation or
correction could last for weeks, or possibly even months.
- Core inflation appears to be starting to pick up modestly. The core Consumer
Price Index ticked up from 1.7% to 1.8% in March,3 which is consistent with
our view that inflation is moving from around 1% to closer to 2%. Higher
inflation should put pressure on the Federal Reserve to change its current stance.
We continue to believe the Fed will begin increasing rates later this year, with
September being the most likely liftoff point.
- Despite the recent strength in the energy sector, we have a negative view
toward energy stocks. The recent bounce can largely be attributed to the
stabilization in oil prices. At current prices for energy stocks, investors appear to
be forecasting a sustainable rise in the price of oil. We do not expect oil prices to
experience a significant advance, which may mean that the energy sector could
be at risk. Even if oil prices do rise, we believe the relative upside in energy is
limited given higher oil prices are already discounted.
Equities Are Treading Water, but Look Resilient
Equities have struggled in recent weeks amid a slowdown in the U.S. economy,
drama over Greece’s debt negotiations, lingering concerns about pockets of deflation
and increased geopolitical tensions. Under the surface, however, it looks to us like
the global economy is gradually recovering. In the United States, the twin drags
of lower oil prices and a stronger dollar appear to be fading and the outlook is
brightening. Europe, which has long been a source of risk, looks to be stabilizing,
with increased monetary policy support helping to combat deflation. A potential
messy exit of Greece from the eurozone is a key source of risk and is holding back
investor confidence, but our view is that we should see at least a temporary deal to
prevent that from happening.
Despite an abundance of negative factors, U.S. equities have held their ground so far
this year. The main headwind for stock prices has been the deteriorating earnings
environment, and while we expect a period of soft earnings to persist, the longer
term outlook does look brighter. Equity valuations may look a bit stretched, but
we do believe that they look attractive compared to government bond markets.
Assuming global economic activity continues to improve, we believe there should be
further room for equities to advance.
1 Source: Morningstar Direct, as of 4/17/15
2 Source: Standard & Poor’s
3 Source: Bureau of Labor Statistics
Last Week's Commentary
Global Economic Risks Remain but Appear to Be Diminishing
April 13, 2015
- Lower oil prices and the rising dollar remain
sources of concern and have been hurting
corporate earnings, but the effects of both
should fade by the second half of 2015.
- The global economy appears healthier than
it has in years, suggesting to us that investors
should overweight equities in their portfolios.
Investors reacted to a range of data and news last week that included a
further digesting of the relatively weak March jobs data, ongoing merger
and acquisition news, signs of weakening corporate earnings and further
evidence of upward pressure on wages. Amid all of the crosscurrents,
U.S. equities finished higher, with the S&P 500 Index gaining 1.7%.1 Most
international markets advanced as well, while Treasury yields and the U.S.
dollar rose.1 Industrials, health care and energy stocks led the way while
telecommunications, utilities and financials lagged.1
Weekly Top Themes
- Corporate earnings may decline in 2015. The combination of the 50% fall in
the price of oil and the 20% rise in the value of the U.S. dollar since last June is
depressing corporate earnings.1 We estimate that were it not for these factors,
earnings per share growth for the S&P 500 would be somewhere around 8% to
10% this year.
- The oil and dollar dynamic may start to fade a bit. We believe oil prices may
have reached or be near the end of the worst of their bearish phase, but we also
think it will take some time for prices to advance given the current supply/demand environment. The bull market in the dollar is likely to continue, but at a
much less frenetic pace.
- Wages are starting to increase. The March payroll data showed that year-over-
year average hourly earnings were up 2.1% and unemployment remained
at 5.5%.2 These figures provide evidence the labor market is tightening as
companies are stepping up efforts to retain workers.
- A Federal Reserve rate hike cycle is likely to kick off later this year, but we
don’t expect dramatic increases. The Fed is attuned to financial markets, and
investors are closely watching the Fed as they wonder when the liftoff will begin
and how high the fed funds rate will go. Our view is that September 2015 seems
the most likely timeframe, and we believe an increase in the fed funds rate to
between 1.5% and 2.0% would be neutral given prevailing economic conditions.
- Equity market technicals appear supportive of further price gains. Although
the market as a whole has moved sideways for much of this year, technical
conditions are healthy. According to data from Strategas Research, 70% of
companies within the S&P 500 are currently in an uptrend.3 That compares to
only 43% of companies at the market peak of October 2007 and only 27% at the
March 2000 high.3
Tailwinds for Equity Markets Should Pick Up
Although several major equity markets are at or near their all-time highs, investors
remain nervous and uneasy about the state of the global economy (as evidenced
by extremely low government bond yields). In recent weeks, investors have been
focusing on relatively weak U.S. economic data, geopolitical turmoil, Greece’s
debt woes and the strength of the U.S. dollar. The last item on this list has been a
particular source of worry, with some fearing the dollar’s strength could jeopardize
the U.S. recovery and trigger debt defaults in emerging economies. In our view,
neither is likely. The rising value of the dollar is consistent with an improving
domestic economy, and it also helps promote global growth.
We believe U.S. growth will bounce back in the coming quarters given the strength
in the labor market and a solid backdrop for consumer spending. Outside the
United States, growth has been patchy but is showing signs of improvement.
Supportive monetary policy remains a powerful force for global growth, and in our
view, structural headwinds and risks to growth have been diminishing. The global
economy remains vulnerable, but we believe it is healthier than at any time since the
Great Recession began.
From an investment perspective, we would point to several considerations in light
of our constructive outlook. The first is that bond market volatility is likely to rise
as we approach the start of the Fed rate increase cycle. Equity market volatility
should move higher as well, but we think equities are more attractively valued than
government bonds. Given this environment, we continue to advocate overweight
positions in equities, underweight positions in Treasuries and commodities and a
neutral stance toward cash.
1 Source: Morningstar Direct and Bloomberg, as of 4/10/14
2 Source: Bureau of Labor Statistics
3 Source: Strategas Research Partners