Confidence About the Global
Economy Is Improving
July 25, 2016
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Equity prices continue to appreciate as investor confidence is slowly improving.
In the month since the Brexit vote, contagion appears to be limited.
The possibility of a spike in bond yields is a key risk, but one we believe is unlikely.
U.S. equities notched a fourth week of gains with the S&P 500 Index climbing 0.6%.1 The primary forces behind the rally remain better-than-expected corporate earnings, stability in the banking sector and a growing sense that equities appear more attractive than bonds given low Treasury yields. In our opinion, the main risk to equities is a possible spike in bond yields. Despite an improving economy and growing prospects for an additional rate hike by the Federal Reserve, however, we think such an event is unlikely.
Weekly Top Themes
- Investors appear more confident about the global economy. The U.S. housing market and weekly unemployment claims are trending in a positive direction, and the eurozone Purchasing Managers’ Index (PMI) is showing growth.2 Additionally, U.S. equities are at all-time highs, credit spreads have declined and cyclical sectors have been outperforming defensive areas.1 These are all positive signals for global growth. The United Kingdom, however, is a growing source of weakness and is likely headed into recession. The post-Brexit U.K. PMI fell from 52.4 to 47.7, the sharpest one-month drop in history.2
- Low bond yields and rising earnings are pushing equity prices higher. This is an unusual combination of factors. Despite low Treasury yields, however, we believe deflationary risks are receding.
- Second quarter earnings have started strong. 30% of the S&P 500 companies have reported results, and earnings are beating expectations by 6% while revenues are ahead by 1.5%.3 Should this pace continue, earnings-per-share would be on track to grow 1.5%.3
- Prospects for a Fed rate hike may be rising. We think solid U.S. economic growth and so-far limited contagion from the Brexit vote mean increasing odds that the Fed will raise rates in 2016. As of now, investors appear relatively complacent about such prospects.
- A rising federal budget deficit will complicate fiscal plans for the next president. The deficit troughed last year and is rising faster than expected in 2016.4 This will make it difficult for either Hillary Clinton or Donald Trump to move forward with additional spending programs.
Several Risks Loom on the Horizon
It has now been one month since the Brexit vote, and so far it appears that global economic data has been resilient. The global banking system in particular has remained solid, which is an encouraging sign. It is too early, however, to suggest that Brexit will not have negative economic effects. There is still much to be determined about how the United Kingdom will leave the European Union. The U.K. itself now appears headed for recession, and prospects remain that economic weakness from the country will cause broader contagion. The key measure to watch will be whether global trade levels begin to slow.
The U.S. economy has been able to maintain its pace of mild acceleration in part due to strong jobs growth and still-solid levels of consumer spending. There are risks that could emanate from the United States, however. The political backdrop is highly uncertain, and we think the odds of a Fed rate hike are higher than investors anticipate. Should the Fed act, another 25 basis point increase in the fed funds rate should not have a significant effect on the economy, but it could trigger additional financial market volatility.
Looking ahead to 2017, one of the most serious risks appears to be the possibility of a sharp upward move in Treasury yields. We do not believe such an event is likely. Government bond yields throughout the world remain extremely low and are negative in several countries, which is dragging U.S. rates down. This should keep yields relatively well contained. We anticipate global growth will improve, however, creating the possibility for downward pressure on bond prices that could spill over into other asset classes, including equities. For now, however, investment conditions appear to have improved over the past several weeks and there seem to be more tailwinds than headwinds for stock prices.
1 Source: Morningstar Direct & Bloomberg, as of 7/22/16
2 Source: Markit
3 Source: RBC Capital Markets
4 Source: Congressional Budget Office
Last Week's Commentary
Equities Reach New Highs as
Confidence Improves Modestly
July 18, 2016
The S&P 500 Index advanced 1.5% last week, marking the third straight
week in which U.S. stocks advanced more than 1%.1 We attribute the recent
rally to three factors: 1) A growing realization that equities are more attractive
than bonds, given low Treasury yields; 2) An improving corporate earnings
outlook for the next 12 months; and 3) A sense that Brexit risks should be
relatively well contained thanks in part to stability in the
Weekly Top Themes
- Second quarter growth should improve, but the economy may slow in the
third quarter. First quarter real gross domestic product growth was 1.1%,2 and
we believe the second quarter should come in at around 2.5%. Looking ahead,
that pace may slow due to deteriorating U.S. trade conditions, declining business
confidence and a possible cooling off in consumer spending.
- Bond yields are likely to trend higher. In our view, low Treasury yields are due
more to overseas forces than domestic factors. In particular, the rising trend of
negative government bond yields throughout the world is causing a significant
drag on U.S. rates. Given positive (if slow) economic growth and modestly rising
inflation in the United States, we expect U.S. yields should rise. As long as the
increase is moderate and due to firmer growth levels, we think such an advance
should support equities.
- We think fiscal policy stimulus is likely in 2017. U.S. monetary policy remains
accommodative, but will likely tighten slowly over the next 18 months. The
prevailing political backdrop suggests we will see a fresh push for infrastructure
spending and increases in other government programs after a new government
is sworn in next year. To help pay for such spending, we think it is likely that we
will see taxation on repatriated foreign earnings.
- Geopolitical risks are rising, but so far have had limited economic and
financial impact. The sheer number of horrific events that have occurred
over the past few weeks is staggering. Terrorist attacks, political instability,
growing violence in the United States directed at police and the attempted
military coup in Turkey have all dominated the headlines. The investment
implications have been modest, but these risks bear close attention for their
broader political implications.
- Historical trends suggest recent highs are bullish for equities. Last week’s new
high for the S&P 500 Index was the first such new high since May 2015.3 Since
1950, this marks the 15th time that it took the index 12 months or more to mark
a new high from the previous one.3 In the 14 previous occasions, the index was
higher a year after the new high every time.3 The average 12-month gain was
18% and the smallest gain was 3.1%.3 In addition, the next major peak for the
stock market occurred a minimum of 15 month after the new high.3
There Are More Reasons to Be Positive than Negative
Despite the recent highs in stock prices, investors remain uneasy about a number
of issues, including uncertainty over global economic growth, monetary policy and
financial market valuations. On balance, we remain cautiously optimistic, and close
with a list of reasons to be positive, and to be cautious, adapted from J.P. Morgan:4
1) Investors appear more comfortable with equity valuations
1) Equities appear attractive compared to bonds, but they are not cheap by historical standards
2) Second quarter earnings are looking decent
2) Corporate earnings-per-share growth may be limited, and growth may be required for stock prices to rise
3) Increased possibilities of fiscal stimulus
3) Fiscal policy has limited ability to expand
4) Interest rate movements should be relatively subdued
4) Complacency over the possibility of higher rates
5) The banking system remains well capitalized
5) U.S. monetary policy is out of bullets
6) The U.S. economy is holding steady
6) Brexit-related fallouts remain unknown
7) Oil price worries and Chinese currency concerns are receding
7) Geopolitical and terrorism risks are growing
8) The prospects of corporate tax reform are growing
8) Regulatory scrutiny could hold back M&A activity
1 Source: Morningstar Direct, as of 7/15/16
2 Source: Commerce Department
3 Source: Strategas, Wampum
4 Source: Adapted from J.P. Morgan, U.S. bull/bear debate week of 7/18/16