Further Equity Gains
Await Earnings Recovery
March 30, 2015
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The initial positive sentiment that occurred in
the aftermath of the recent Fed meeting has
faded a bit.
Earnings downgrades have been putting
pressure on equity prices, but we anticipate
that corporate earnings will improve in the
second half of the year.
Economic growth should reaccelerate and the
Fed is still likely to raise rates later this year.
Downward pressure on U.S. equities returned last week, with the S&P 500
Index falling 2.2%.1 This marked the second-largest weekly downturn of the
year and the fourth negative week in the last five.1 Some of the decline can
be attributed to fading positive sentiment that came in the wake of the recent
Federal Reserve meeting. Ongoing negative earnings forecasts have taken
their toll as well. All market sectors were in negative territory last week, with
financials, technology and industrials losing the most ground and consumer
staples and energy holding up the best.1
Weekly Top Themes
- Fourth quarter growth was a bit weaker than expected, but the consumer
sector showed strength. Despite expectations that it would be revised upward,
the gross domestic product growth report remained unchanged at 2.2%.2 One
bright spot was that real spending hit its strongest level since 2006, suggesting
that consumers have benefited from the drop in energy prices.2
- Corporate earnings estimates continue to weaken. Falling oil prices and
the rising dollar have prompted analysts to cut expectations. Earnings for
U.S. companies are now expected to grow 2% in 2015, down from 8% at the
beginning of January.3 At the same time, sales are expected to contract by
1.0%, compared to growing by 2.5%.3 Downgrades have been concentrated in
the energy sector, but the fallout from the strong dollar has also been hurting
- Concerns over an economic slowdown should be temporary. Given the
recent spate of relatively weak economic data, we expect fears of a slump will
persist over the next few months. Longer term, however, we believe stronger
employment growth and improving consumer spending levels will cause some
degree of economic optimism to return. We still expect the Fed will begin rate
increases this year, which should reduce concerns over deflation. This shift should
also cause bond yields to rise.
- The trend of global growth decoupling is persisting. Notwithstanding some
recent data, the U.S. economy is still accelerating while China is showing signs
of a deceleration. Within Europe, we are also starting to see evidence of different
growth rates, with Germany appearing to improve as France, Italy and Greece
- Negotiations between Greece and the European Union remain stalled.
Although we have not seen much progress in talks lately, we still expect a
relatively benign outcome and do not anticipate that Greece will exit the
European Union. Nevertheless, the possibility of some sort of significant
financial disruption cannot be ignored.
Improving Growth Should Eventually Help Risk Assets
Equities have been struggling to find direction, with sagging profits weighing prices
down and still-ample liquidity providing a tailwind. In the immediate aftermath of
the recent Fed meeting, investors interpreted its statement as a sign that interest rate
hikes may be delayed, but the Fed really hasn’t changed stances. It has indicated all
along that any rate moves would be data dependent and has done little more than
acknowledge that recent data has been somewhat disappointing. In our view, at
least some of the recent softness is due to harsh winter weather and the West Coast
port strikes, both of which are temporary factors. Looking ahead, we think the
employment picture remains positive and we expect the broader data to rebound.
Despite the recent deterioration in earnings trends, U.S. equities have still held up
reasonably well. We expect earnings data to remain volatile due to the twin factors of
lower energy prices and a stronger dollar. However, earnings should improve in the
second half of 2015 as the economic recovery regains traction. Stock prices are likely
to remain volatile as well as investors digest earnings data and await more signals
from the Fed. When the Fed does raise rates, it should do so slowly and carefully
and it should serve as an acknowledgement that the economy has strengthened.
Outside of the U.S., policy is still in an easing trend, which should help the global
economy. Together, all of these factors should mean that we see solid returns for
equities, particularly compared to bonds and cash. But until the earnings picture
improves, gains will be tougher to come by.
1 Source: Morningstar Direct, as of 3/27/15
2 Source: Bureau of Labor Statistics
3 Source: MRB Partners
Last Week's Commentary
A Relatively Dovish Fed Statement
March 23, 2015
A more dovish-than-expected Fed statement
pushed back expectations for rate increases
and provided a boost to equity prices.
We continue to believe the Fed will begin
increasing rates in 2015.
Global policy remains supportive for equities
and we continue to have a pro-growth
Last week featured some disappointing economic data and further downward
revisions of corporate earnings estimates, but investors focused heavily on last
week’s Federal Reserve policy meeting. The Fed’s statement was more dovish
than expected, and investors interpreted the comments as an indication that
rate increases would not happen as soon as some anticipated. As a result,
the U.S. dollar lost some ground and equities rallied, with the S&P 500 Index
snapping a three-week losing streak to gain 2.7%.1 Health care was the best-performing
sector, while materials was the only area of the market to end the
week in the red.1
We Still Expect Rate Increases Will Begin in 2015
The main headline from the Fed’s statement was the removal of the word “patient”
when discussing the path toward rate increases, but almost every other aspect
signaled no immediate hurry to act. The Fed indicated that it still saw some slack in
the labor market and noted that inflationary pressures remain absent.
Our view is the Fed is reacting to the strong upward trend of the dollar, muted wage
increases and signs that economic growth has become sluggish. Federal Reserve
officials understandably want to retain some flexibility, but we believe rate increases
at some point over the coming months are almost inevitable. Our best guess would
be that the Fed will enact its first rate increase at its September policy meeting,
rather than in June as many had previously anticipated.
Weekly Top Themes
- The manufacturing sector has been struggling. Industrial production increased
at a disappointing 0.1% rate in February, while manufacturing output fell 0.2%.2
Some of the weakness can be attributed to temporary factors such as the harsh
winter weather and the West Coast port strike, but we also believe that the
strength in the dollar has been hurting manufacturing.
- Lower oil prices and the stronger dollar bring both positives and negatives.
Specifically, we believe that while these trends are hurting U.S. corporate
earnings results and expectations, they are also net positives for the U.S. economy.
- We expect several market trends to continue. The months-long themes of
falling commodity prices and a rising U.S. dollar may be taking a break, but
those trends are probably not over. At the same time, we expect equities will outperform bonds in the coming months and European equity strength will
persist in the near-term.
The Global Economy Should Gradually Accelerate, Providing a Tailwind for Stock Prices
It appears the world economy may be at the beginning of a gradual leadership
transition from the U.S. to non-U.S. markets. With the Fed likely to begin
increasing rates later this year, the reflation banner is being passed from the U.S. to
the euro area and Japan. Many emerging market economies should also benefit from
interest rate cuts, but it will take some time before economic growth accelerates.
Reflationary trends have been a critical driver of equity market performance in
recent years and we do not believe that the era of reflation is over. Many central
banks are still in the early stages of easing. In the U.S., Fed policy remains highly
accommodative and even when the Fed finally does begin raising rates, it will be
starting from such a low level that monetary policy should remain supportive for
equities for some time.
Given this backdrop, we continue to believe that equities look attractive and expect
they should benefit from a gradual acceleration in global growth. With commodity
prices likely to remain soft, we tend to prefer commodity users rather than
producers, and have a bias toward the non-commodity cyclical sectors. Over the
coming months, we expect upward pressure on the value of the dollar to continue,
but do not anticipate the dollar’s rise will continue at the same breakneck pace we
have seen in recent months. At the same time, we expect to see a gradual rise in
global bond yields as the Fed approaches the start of interest rate increases.
1 Source: Morningstar Direct, as of 3/20/15
2 Source: Federal Reserve