Equity Outlook: Long-Term
Looks Clearer Than Near-Term
March 20, 2017
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Equities and bond yields moved higher as the Fed raised rates without indicating it would quicken the pace of increases.
Investors remain optimistic about the political backdrop, but we think a lack of policy clarity presents risks.
A number of risks could spark a near-term equity correction, but we retain a constructive longer-term outlook.
The Federal Reserve’s decision to raise interest rates by 25 basis points, while keeping its dovish tone, was the big story last week. U.S. equities finished slightly higher, with the S&P 500 Index rising 0.3%.1 Treasury prices also advanced after falling the week before.1 Among stock sectors, income-oriented bond proxies outperformed, while health care and financials sagged.1
Investors Need Clarity on the Trump Economic Agenda
Political observers have been focusing on the GOP’s health care plan and President Trump’s proposed budget. Both face an uncertain political future, but the president and Congress are clearly looking to significantly reorient the federal government.
Both initiatives could shape economic growth and financial markets. But tax reform will likely have the greatest impact. Any tax reform plan is certain to address corporate tax repatriation. At present, U.S. companies are estimated to hold over $2 trillion in foreign income overseas.2 Enacting a plan that returns this money to the U.S would allow the government to tax these profits and produce revenue that could help pay for other tax cuts or infrastructure spending.
In our view, the chances of passing such tax reform are high and the markets have already priced in this change. This is one reason stock prices and bond yields have both risen since the election. Investors are anticipating an increase in tax revenues from repatriation that could fuel economic growth. If any such plan is smaller in scope than investors anticipate, it could present downside market risks.
Weekly Top Themes
- The Fed signaled that it will continue to raise interest rates slowly. The central bank’s relatively dovish statements seemed to signal that it intends to continue a slow and moderate pace of rate hikes.
- U.S. economic growth appears to be accelerating modestly. In our view, manufacturing is improving, home demand is on the upswing and consumer spending is stable. At the same time, inflation appears to be creeping higher.
- We expect Chinese growth to slow. We do not anticipate a hard economic landing, but slowing Chinese growth represents a risk to the global economy.
- Equities may be growing more expensive in absolute terms, but still look relatively attractive. Given the strong run-up in prices over the last year, equity valuations may be less attractive. But we still think they appear better valued than Treasuries or other government bonds.
Several Risks Could Cause a Setback or Correction
Equities and other risk assets have continued to be resilient over the last several weeks, but higher-risk areas of the market (small cap stocks, cyclical sectors and some fixed income credit sectors) have been flagging to various degrees.1 We have been suggesting for some time that the broader equity market may be slightly overextended and could be due for a setback or correction.
A number of catalysts could trigger such an event. Economic data has almost continuously surprised to the upside, and a string of disappointments could trigger a change in sentiment. Additionally, investors could become more impatient or less optimistic about the prospects for pro-growth legislation from Washington. Investors also seem complacent about Fed rate hikes, especially the possibility that the Fed could become more aggressive should economic and inflation data continue to move higher. Slowing Chinese growth could present risks, as could a flare-up in one of many geopolitical hot spots. Should any of these events happen in isolation, it probably wouldn’t surprise investors, but multiple simultaneous occurrences could trigger a risk-off phase.
We think it makes sense to approach equity markets cautiously in the near term, but at the same time, the 6- to 12-month outlook appears moderately constructive. Improving economic growth, rising corporate earnings and the likelihood of rising interest rates make stocks look more attractive than bonds. Investors may need to weather some additional near-term volatility, but we continue to believe that overweight positions in equities makes sense for the long term.
1 Source: Morningstar Direct and Bloomberg, as of 3/17/17
2 Source: Congressional Joint Committee on Taxatation
Last Week's Commentary
Equities Could See a Setback,
But This Bull Market Isn’t Over
March 13, 2017
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The equity rally appears to be taking a breather, as investors await signals about the economy, political backdrop and Fed policy.
We expect the Fed will raise rates this week and are watching for signs that the central bank may be becoming more aggressive.
On balance, we think equities and other risk assets still appear attractive.
U.S. stock prices sank last week. The S&P 500 Index fell less than half a percent and is still up over 6% for the year, but the small cap Russell 2000 Index declined 2%, making it marginally up for 2017.1 Within the S&P 500, the energy and real estate sectors were hit the worst last week, while technology performed best.1 In other asset classes, Treasury yields rose in anticipation of a Fed rate hike this week, the U.S. dollar declined and oil prices fell sharply.1
Weekly Top Themes
- The labor market continues to be a source of economic strength. February’s data showed healthy growth of 235,000 new jobs and a decline in the unemployment rate to 4.7%.2 Additionally, wages rose 2.8% year-over-year.2 This should be a positive for consumer spending, but may also drag down corporate profit margins.
- The Federal Reserve’s forward guidance will be key. Following the strong labor data, we expect the Fed will raise rates this week. Perhaps more important than the actual hike will be the accompanying statement. The Fed may signal a more hawkish tone that could indicate more aggressive future rate hikes than investors currently anticipate.
- The geopolitical backdrop remains a risk for investors, but we remain optimistic about economic growth. Financial markets face many uncertainties, including the French election, ongoing debt issues in Greece, a more aggressive North Korea and political uncertainty in the United States. On balance, however, we think additional fiscal stimulus around the world should boost global economic growth.
- The U.S. energy sector may remain under pressure. Energy stocks have struggled this year, with that sector down 5% compared to the broader market up 6%. As a result, the energy sector has given back all of the relative gains posted in 2016. We expect energy companies may continue to struggle, given that rising oil inventories will likely put a cap on oil prices.
- Investor sentiment may be overly optimistic. In our view, investors may be overlooking economic and political risks. We are not bearish toward equities and other risk assets, but we believe markets could be vulnerable to shocks and volatility is likely to rise.
Investors Await Financial Market Signals
Equity markets have rallied strongly since the election, but appear to have settled into more of a trading range in recent weeks. Investors may be taking a pause, looking for catalysts that could determine the future direction of equity prices.
The state of the global economy could provide one such set of signals. U.S. economic data have been generally strong over the past several months and business and consumer confidence seem to be rising. Outside of the United States, growth appears solid, and we may see an uptick in global trade levels. There are still risks to the global economic outlook, including the slowing Chinese economy and rising protectionism around the world, but on balance we think the world economy should accelerate unevenly.
The recent sharp drop in oil prices is another possible sign for equity markets. Some investors wonder if we will return to the 2014 and 2015 period when collapsing oil prices triggered a corporate earnings recession and downturn in equities. However, today the world is no longer in the midst of a broad deflation crisis as it was then. We do not expect oil prices to crash, but expect downside pressure to persist.
This week’s Fed meeting is also a source of intense focus. The advance in Treasury yields last week looks to be a signal that bond markets are finally accepting the rising fed funds rate, which should provide a floor for bond yields. Given evidence of stronger economic growth, we could see the Fed become slightly more aggressive about its rate policies, but probably not to the point that it would derail the equity bull market.
On balance, we think the risks are skewed to the upside for stocks. While we could see higher volatility and a near-term correction, we expect equities to move higher over the coming year.
1 Source: Morningstar Direct, as of 3/10/17
2 Source: Bureau of Labor Statistics