Markets Warrant Both a
Pro-Growth Stance and Caution
September 26, 2016
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The Fed will likely raise interest rates in December, although policy should remain accommodative.
Government bond yields will likely remain low despite mounting evidence of improving growth. This should benefit equities.
Equities may be expensive compared to their own history, but they appear attractive compared to bonds and cash.
U.S. equities rallied again last week, with the S&P 500 Index climbing 1.2%.1 Investor sentiment improved due to generally dovish tones from the Federal Reserve and Bank of Japan. Real estate and utilities led the week’s rally, while energy lagged despite an increase in oil prices.1
Weekly Top Themes
- The Fed signaled a likely rate hike in December. To no one’s surprise, the Fed did not raise rates at its meeting last week. But it clearly indicated that a hike is coming soon, provided economic growth remains on track and the global financial system does not endure an additional shock. The Fed statement included this new, unambiguous statement: “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”
- U.S. inflation is slowly creeping higher. The core Consumer Price Index climbed 0.3% in August and is up 2.3% year-over-year.2
- 2017 economic growth may look similar to 2016. At the beginning of the year, we expected U.S. growth to remain slow but avoid a recession. At this point, we expect to see a similar environment next year, but we think it is possible we may see even slower levels of growth.
- U.S. equities appear more attractive than international stocks. Compared to overseas alternatives, we believe the U.S. market features better economic growth, stronger earnings trends and more supportive monetary policy. If global trade levels increase, our view would be more constructive toward non-U.S. equities.
- The U.S. political environment looks to be a mixed bag for equities. At this point, Hillary Clinton seems to hold the edge in the race for the White House. Compared to Donald Trump, Clinton’s policies offer more clarity and continuity, which would be a net positive for equity markets. Nevertheless, it appears she would push for more government regulations, and both candidates have adopted anti-globalization and anti-free-trade policies. That’s not great news for stocks, and given globalization has been a major deflationary force for decades, it also isn’t great news for bonds. One silver lining is that we see growing prospects for increased infrastructure spending and possible corporate tax reform.
Equities Aren’t Cheap, but Appear Relatively Attractive
Equity prices have advanced over the last few weeks, as central banks signaled they will continue to promote growth and provide liquidity. The Fed remains the only central bank pondering a rate increase, although it has signaled it will move cautiously. This backdrop is likely to suppress government bond yields despite mounting evidence of global economic growth improvements. Such an environment is supportive for risk assets.
As such, we continue to believe in a mildly pro-growth, pro-risk investment stance. We think equities will likely improve against a backdrop of record-low interest rates and modestly improving growth. When the Fed finally raises rates again (probably in December), it could jolt the markets. But even with another 25 basispoint increase, the fed funds rate would remain extremely low given the growth and inflation environment.
At the same time, we understand why many investors are cautious. The world continues to recover from the financial crisis and Great Recession, remains in deleveraging mode and navigates a wide array of geopolitical uncertainties. Compounding this backdrop, pockets of the equity market are somewhat expensive historically. Given low bond yields and meager cash returns, however, we think equities look attractive on a relative basis. And we expect equity prices to continue grinding slowly higher over the coming year.
1 Source: Morningstar Direct, as of 9/23/16
2 Source: Bureau of Labor Statistics
Last Week's Commentary
Equities Appear More Attractive
than Other Asset Classes
September 19, 2016
Global monetary policy experiences renewed focus as fears grow over a potential renewed tightening phase. In our view, monetary policy remains supportive of risk assets.
We believe U.S. and global economic growth should improve modestly over the coming year, which would be a positive for corporate earnings and equity prices.
U.S. equities experienced a volatile week, as monetary policy dominated the headlines. Dovish comments from Federal Reserve officials tamped down speculation that the central bank was on course to tighten aggressively. Investors are also closely watching any movement by the Bank of Japan to spark economic growth. Weaker economic growth data and rising U.S. political uncertainty were also factors last week. For the week, the S&P 500 Index gained 0.6%, as technology outperformed and financials and energy lagged.1
Weekly Top Themes
- The strong patch of summer U.S. economic data may have ended. Following weak Institute for Supply Management readings in previous weeks, August retail sales declined 0.3%.2 This marks the first pullback since March,2 and bears watching for a broader downtrend into September.
- The recent advance in bond yields may act as a headwind for equities. Sovereign yields have been advancing since July, but have only recently negatively affected equity markets. We don’t believe the increase will depress stock prices, but it may limit upside potential.
- Corporate earnings expectations are climbing slowly. Following a modest second quarter improvement, analyst expectations for future quarters have climbed in recent weeks.3 The largest increases are in the technology, health care and consumer discretionary sectors.3
- Equities may continue to climb in 2016, based on historical trends. Strategy group Fundstrat shows that since 1940, when stock prices increased more than 5% by mid-September, 87% of the time they rallied further in the last three-and-a-half months of the year.4 As of Friday’s close on September 16, the S&P 500 Index is up 6.3%.1
- Equity gains may be tough to come by, suggesting this remains a stock-picker’s market. In our view, the risk-reward trade-off for stocks is mediocre based on current valuations. Yet, equities remain relatively attractive with bonds appearing overvalued and cash returning close to zero. We believe selectivity will continue to be critical, making an implicit argument for active management.
Economic Growth and Policy Remain Equity Friendly
We believe global economic growth should continue improving modestly over the coming year. The United States will likely remain the primary growth engine, and it is reassuring that employment trends have remained solid despite many global headwinds. We believe income levels and consumer spending are likely to pick up in the coming quarters, which should help retail sales. Manufacturing has been uneven and global trade has struggled during this economic cycle, but we think employment and demand trends point to an eventual improvement in both areas. Outside of the U.S., the eurozone appears to have navigated the Brexit fallout without significant damage, while China’s economy has remained relatively resilient. This backdrop should be a positive for corporate earnings, and ultimately equity markets.
Global monetary policy has come into renewed focus in recent weeks. Some investors fear the world is entering a renewed tightening phase due to the European Central Bank’s decision not to expand its bond-buying program, confusion over Bank of Japan policy and the prospects for Fed rate hikes. In our view, worries are premature that the ECB and BOJ will not provide additional support. And even as the Fed considers raising rates, it remains focused on supporting economic growth and should do so slowly. Overall, monetary policy appears supportive of risk assets.
As such, we believe it makes sense to retain a mildly pro-growth, pro-risk investment stance. A number of risks exist, and the U.S. elections are currently in focus. The odds of a Clinton victory have fallen slightly in recent weeks. Prospects for a Trump victory have unsettled markets, given the uncertainty surrounding his economic policies. Investors are also worried about a sharper spike in bond yields. We would not ignore any of the risks, but still believe that equities appear more attractive than bonds or cash.
1 Source: Morningstar Direct, as of 9/16/16
2 Source: Commerce Department
3 Source: RBC Capital Markets
4 Source: Fundstrat