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
Last Week's Commentary
The Equity Rally Should Persist,
but Expect Bumps
February 13, 2017
Download & Print:
Equities continued to rally based on anticipation of pro-growth economic policies from Washington.
Economic and earnings growth also continue to solidify, supporting the case for a continued equity market rally.
Nevertheless, potential risks to this outlook include rising bond yields, the advancing U.S. dollar and political uncertainty.
As has been the case for the past couple of months, investors continued to be highly attuned to the political backdrop last week. Early in the week, concerns over the president’s immigration and trade policies cased unease, but sentiment improved on Thursday after Donald Trump signaled a
near-term announcement on tax reform. For the week, the S&P 500 Index rose 0.9%, with the industrials, technology and consumer sectors leading the way.1 Energy and income-oriented sectors lagged, with energy being the only sector to experience negative returns.1
Weekly Top Themes
- Corporate earnings continue to rise and are on their best pace in over two years. As reporting season winds down, fourth quarter earnings are set to grow between 8% and 9%.2 This would mark the best performance since the third quarter of 2014.2
- Despite a recent pullback, we expect the U.S. dollar to continue to strengthen. The dollar has rallied strongly since the election, but the rally has taken a breather in recent weeks. We could see some additional near-term consolidation, since the greenback may have been overbought. However, we expect a combination of accelerating growth and rising interest rates will likely put continued upward pressure on the currency.
- The U.S. political backdrop remains a wildcard for investors. In general, investors remain optimistic about the prospects for a pro-growth Trump Agenda. Tax reform, fiscal stimulus, regulatory revisions and more infrastructure spending would promote economic growth. But investors are also wary about the president’s priorities and his propensity to lash out at individuals and specific companies with whom he disagrees.
- The federal budget deficit is expanding, which could complicate the political background. On a rolling 12-month basis, the deficit rose to $587 billion for fiscal year 2016, up from $405 billion the prior year.3 Tax revenues have declined, while spending levels have advanced.3 These trends will make any tax cuts and spending plans problematic.
- We expect to see tax reform legislation passed, but the details are still murky. At present, most are focusing on a possible border adjustment tax, which would tax goods imported into the United States. Such a tax would increase revenues and make broader tax reforms more possible, but some (including the president) appear skeptical about its merits. The border adjustment tax is an important issue, but even if it winds up not being a part of the final GOP plan, we still expect some sort of tax reform legislation to pass.
We Suggest a Pro-Growth Investment Stance
Equity markets have surged higher since the November elections. Some question whether markets have come too far, too fast and even if stocks are in a bubble. While some market areas may look expensive (e.g. bond market proxies such as utilities), we do not believe equities as a whole are close to bubble territory.
That said, we think the bull market skeptics are right to point out some risks. Late last year, investors were deeply concerned that the rapid rise in bond yields and the soaring value of the U.S. dollar could derail the ongoing economic expansion. These trends have moderated in recent weeks, easing this concern. If these rapid uptrends resume, it could be a source of renewed worry. Additionally, the political backdrop has the potential to trigger a setback in economic growth and the equity rally. If President Trump remains focused on immigration and trade restrictions, we think it would be a negative for growth. Even if he shifts his attention elsewhere, investors must face the possibility that expectations for tax reform and fiscal stimulus may be too high.
Despite these possible risks, we think the scales favor continued economic expansion, improving corporate earnings and rising equity prices. International markets will probably begin outperforming the U.S. at some point, as non-U.S. markets appear relatively inexpensive and may have more upside potential. For now, though, we continue to think that U.S. stocks look more attractive thanks to better relative economic and earnings growth.
1 Source: Morningstar Direct, as of 2/10/17
2 Source: Strategas Research
3 Source: Congressional Budget Office & Strategas Research