Investors generally focused on the positives last week. They digested continued solid earnings reports and remained optimistic about President Trump’s economic agenda. The S&P 500 Index rose 0.7%, marking its fifth consecutive week of gains.1 At the same time, the Dow Jones Industrial Average capped off the week with 11 straight days of gains.1 Treasuries also rallied, as yields moved lower for the week.1
Equity prices have been rallying on expectations that the president and Congress will enact tax reform, fiscal spending and regulatory changes that will boost growth. However, President Trump’s legislative agenda appears to be stalled. Health care reform seems delayed over timing and specifics. And tax and spending legislation appears caught in a battle between those favoring growth and those concerned about the budget. President Trump will likely focus on prioritization in his speech Tuesday night. But if his focus appears hazy or if real progress is lacking, equity markets may react more negatively to the political backdrop.
The recent behavior of equity and bond markets creates a conundrum for investors. Equity markets are rallying based largely on expectations for stronger economic growth, while bond yields have been falling and seem priced for economic stagnation. Which signal is correct? The economic environment may grow more complicated in time, but for now we expect acceleration to continue. The Federal Reserve is slowly tightening policy, but it would not move aggressively without a significant and unlikely inflation scare. Consumer spending and business investment are also rising, which should be positive for near-term economic growth.
The challenge for investors, however, is that few areas of the global financial market offer compelling value. Global equity markets are more expensive than several years ago and are probably fairly valued. Government bond yields are likely to rise, suggesting bond prices may be at risk. And very low short-term interest rates mean cash offers meager returns.
So what to do? We expect equity prices and bond yields to grind unevenly higher over the coming months. As such, we continue to expect equities to outperform bonds and cash. We believe a moderately pro-growth investment stance is warranted, given our expectation that economic growth and corporate earnings are both improving.
Within equity markets, we continue to believe U.S. stocks are better positioned than most non-U.S. markets. The eurozone, Japan and many emerging markets would appear to offer better long-term growth prospects, and international equities look generally more attractively valued. We expect equity market leadership to shift at some point, but for now U.S. stocks should benefit from stronger growth tailwinds.
Last Week's Commentary
We Are Growing Less Positive
(But Not Negative) Toward Equities
February 21, 2017
Download & Print:
We believe investors are overly complacent about the state of the global economy and the political backdrop.
We remain cautiously optimistic toward equities, but think the pace of recent gains is unlikely to persist and that risks will rise this year.
Can the Equity Rally Continue?
Equity markets have increased since the U.S. elections for two principal reasons: optimism over a pro-growth legislative agenda from Donald Trump and improving U.S. and global economic and earnings growth.
The second factor actually began emerging in mid-2016. The S&P 500 Index advanced close to 7% between its summertime low and Election Day, and has subsequently risen nearly 10%.1 Since this time last year, when investors were focused on deflation and recession risks, the S&P 500 has climbed nearly 30%.1 Bond yields have also risen significantly in recent months: the 10-year Treasury yield climbed close to 50 basis points since the election and more than 100 basis points since the mid-2016 lows.1
Simply put, we do not believe this pace of gains is sustainable. We think that economic growth will continue improving and the economy and markets will benefit from the legislative backdrop. But the intense pace of gains implies that investors believe both trends will persist without interruption. We think this is unlikely and expect bumps along the way in economic and earnings data. The political environment will also likely provide its share of setbacks.
Investors May Be Looking Past Economic Risks
For several years, the U.S. economy has benefited from a Goldilocks scenario of low inflation and supportive monetary policy that has allowed slow, but consistently positive growth. We think the economy is now moving into a slightly higher gear. Falling unemployment and slowly rising wages are boosting consumer spending. Corporations are increasing spending levels and engaging in equity-friendly practices such as dividend increases and merger activities. Additionally, while the Federal Reserve is starting to raise interest rates, policy remains extremely accommodative and should help economic growth.
Outside of the United States, we also see reasons for optimism. Brexit risks notwithstanding, the eurozone appears to be recovering. In China, fears of a hard landing have receded and worries over a disorderly currency devaluation have faded as Chinese policymakers have ramped up their own fiscal stimulus to help the economy.
And we would also point out that the corporate earnings backdrop is also improving. A key drag on earnings—rapidly falling oil prices—has probably run its course. And the quickly rising dollar remains present but has moderated. At some point, however, conditions for continued growth may become trickier, and the economic environment will likely grow more uncertain. Inflation appears to be climbing slowly and interest rates have probably bottomed. A stronger dollar also presents a risk. Together, these factors may conspire to tighten financial conditions. We don’t expect these trends to emerge quickly, but believe the Goldilocks environment driving growth will likely begin fading by the end of 2017.
In short, we remain constructive on the U.S. and global economic outlooks, but believe that anxiety and economic volatility will probably rise. We think economic growth will remain solid for some time, but risks are growing that the U.S. and global economies will falter in 2018.
The Political Environment Is Becoming More Complicated
For months, the direction of the stock market has closely tracked the political backdrop. When President Trump has focused on possible tax cuts or regulatory changes, equities have generally increased. But markets faltered when he turned his attention to limiting trade or immigration. At some point, we expect investors will more closely scrutinize President Trump’s actual policy actions rather than his rhetoric.
Despite the wide-sweeping nature of many of Donald Trump’s statements, the reality is that the Constitution requires the president to work with Congress to enact legislation. And the judiciary acts as an important check against presidential overreach.
From a practical perspective, this means that the actual tax, spending and regulatory policies the Trump Administration are promising will likely be less far-reaching than many investors hope. We think Washington will pass a fiscal stimulus package, but it will probably take longer than most expect and the scope may well be more modest. The same is likely true with tax reform.
Additionally, the fiscal tone from Washington is somewhat concerning from a budget perspective. President Trump talks about tax cuts, but also discusses areas to increase spending, such as the military. It is unclear how much Congress shares this focus, but we think investors are overly optimistic about the legislative agenda.
We Have Grown Less Bullish Toward Stocks
As a result of these developments, we think the easy gains for equities are in the rearview mirror and we are growing less positive toward the stock market. We do not believe the current bull market has ended, but the pace and magnitude of the gains we have seen over the past year are unlikely to persist.
To be clear, this does not mean we have turned negative toward equities, but we think markets may be vulnerable to negative economic, earnings or political surprises. Market sentiment has improved over the past year while valuations have become less attractive.1 It is somewhat worrisome that investors are becoming more complacent. On balance, we think the near- and long-term equity outlook remains reasonable given the economic and earnings backdrop. It is just that with the S&P 500 currently sitting at around 2,350 at least some positive expectations are already baked into the market.1
From a positioning perspective, we think it still makes sense to remain overweight equities and underweight government bonds. If evidence mounts to reveal a slowing economy or faltering earnings, we would revisit this stance, but we do not expect that to happen for at least the balance of the rest of this year.
Over the short-term, we would point out that markets really haven’t had much of a pause or correction in recent months, which could mean stocks are overdue for some sort of setback. Over the long-term, we still expect equity prices to continue climbing. But increases will likely be uneven, with greater dispersion and more significant downside risks.
1 Source: Morningstar Direct and Bloomberg, as of 2/17/17