Improving Corporate Earnings
May Lift Stock Prices
April 24, 2017
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We believe the decline in bond yields is a short-term trend that should reverse.
Political uncertainty is growing in the United
States and Europe, but we do not expect
market-related geopolitical risks to rise
As long as corporate earnings continue to
improve, they should provide a tailwind for
The political environment dominated market sentiment last week, as investors
focused on rising uncertainty in the United States, France and the U.K. Equities
posted gains after two weeks of declines, with the S&P 500 Index rising 0.9%.1
Small cap stocks outperformed, while the U.S. dollar and oil prices declined.1
Weekly Top Themes
- First quarter corporate earnings are looking strong. With nearly 25% of S&P
500 companies by market capitalization reporting, earnings results are beating
expectations by an average of 6%, while 75% of companies are surpassing profit
expectations.2 Overall earnings-per-share growth is tracking a 10% increase.2
- Manufacturing activity is slowing, but still growing. The flash Purchasing
Managers Index for April came in below expectations and has now declined for
three months.3 Manufacturing activity is still expanding, but the pace of growth
is trailing off.
- Despite recent declines, we expect Treasury yields will rise. The 10-year
Treasury yield declined from 2.62% in mid-March to as low as 2.18% recently.1
We believe this is a counter-trend rally and expect yields to resume climbing
from the low of 1.37% last July.1
- Equity volatility appears to be on the rise. While volatility was quite low from
a historical perspective in the first quarter, markets have churned more in recent
weeks. We expect volatility to rise over the course of 2017.
- Stock prices remained resilient over the past couple of months in the face of
several risks. Equities rose strongly to start 2017, but have since traded sideways.
Political setbacks for President Trump’s pro-growth agenda, falling bond yields
and escalating geopolitical uncertainty have all weighed on stocks, but we
think downside risks should remain contained. We expect improving corporate
earnings will eventually help lift stock prices.
We See Reasons for Concern, but Remain Optimistic
The equity rally in place since the election has faded, and bond yields have more
recently declined while defensive equity sectors have outperformed. This has sparked
concern that we may be entering a period of weaker global economic growth and
possibly an end to the years-long equity bull market. We doubt this is the case.
More likely, we have been experiencing a consolidation of overbought conditions in
equities while economic data has softened slightly.
In our view, the recent decline in bond yields is at least in part an overreaction
to some modestly disappointing economic data. We expect economic growth to
continue accelerating in the United States, and believe global growth is broadening
and strengthening. Tighter monetary policy should also put upward pressure on
yields. At this point, the Federal Reserve seems to have entered a tightening phase.
It would take a significant disruption in economic data for the Fed to discontinue
its rate-hiking campaign. We don’t expect the Fed to become overly aggressive, but
believe rates will continue to rise.
Rising geopolitical tensions have been another source of concern for investors. In
the United States, the inability of the Trump administration to push its economic
and tax agenda through Congress has diminished expectations for a pro-growth
political backdrop. We still expect an economic boost from tax reform and regulatory
changes, but the timing will likely be later than previously hoped and the overall
effect may be weakened. Outside of the United States, investors are focused on a
highly uncertain election in France and ongoing Brexit action in the U.K. Both
situations are creating headline risk and possible negative economic and market
effects, but we expect risks to be relatively well contained.
Equity market consolidation and downward pressure on yields may persist for
the near-term, and we believe that volatility will remain relatively elevated. We
acknowledge that some downside risks are growing, but also believe that both bond
yields and stock prices should climb over the next 6 to 12 months, especially if
corporate earnings continue to improve.
1 Source: Morningstar Direct, as of 4/21/17
2 Source: RBC Capital Markets
3 Source: Market
Last Week's Commentary
We Encourage Investors to
Ride Out Near-Term Turbulence
April 17, 2017
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Equities endured a second week of negative returns for the first time since January.
The Trump administration has proved to
be unpredictable in matters of geopolitical
and economic policies, which causes more
uncertainty for markets.
- We think volatility will rise from here, but
staying with a pro-growth investment stance
The broad move away from equities continued for a second week as investors focused on
escalating risks in Syria, Afghanistan and North Korea. The S&P 500 Index fell
1.2%, marking the first back-to-back weekly declines since January.1 Treasury
yields also fell, the dollar was down and oil and gold prices rose.1
Weekly Top Themes
- Investors have so far reacted only modestly to recent U.S. military action, but it does present possible financial and market risks. In particular, recent
actions highlight the unpredictability of President Trump’s geopolitical views
since he was adamantly against previous missile strikes in Syria. Unpredictability
isn’t necessarily a bad trait for a politician, but it does increase the degree of
unknowns for financial markets.
- Likewise, the Trump administration’s economic views do not match those of
the campaign. As President, Trump has so far softened his position on trade
deals and has put little focus on possible infrastructure spending increases.
Perhaps most surprisingly, Trump recently indicated he may re-nominate Janet
Yellen as Fed Chair despite previous harsh criticism of her tenure.
- We do not believe the rally in Treasuries is a signal of weaker economic
growth. There may be more negative economic surprises from here, but those
would come after a nearly uninterrupted string of positive ones.
- Corporate profit margins may come under pressure, which would act as a
headwind for earnings. With wage levels on the rise, companies may have a hard
time passing along higher costs to consumers. This could be particularly difficult
for many U.S. corporations since compensation costs represent two-thirds of
total U.S. business costs.2
- We believe non-U.S. equities are on the verge of an outperformance trend. We
still expect U.S. stocks to produce positive returns over the coming year, but U.S.
equities are likely to lag their international counterparts.
Despite Growing Risks, Equities Should Outperform Bonds
U.S. equities have essentially treaded water over the last two months following a
strong post-election rally. At the same time, bond yields have retreated, commodity
prices flat-lined and inflation expectations have come down. While some of these
moves represent a consolidation from overbought equity conditions, we also think
they reflect rising investor concerns over a number of risks.
Chief among the risks may be a growing recognition that political optimism was
too high. The failure of the Republicans to “repeal and replace Obamacare” calls
into question the future for tax reform and other big-ticket economic items. At a
minimum, investors are ratcheting back expectations for how effective pro-growth
policies could be over the next 6 to 12 months.
At the same time, expectations for economic growth have declined somewhat. We
don’t think we will see a slowdown, but the near non-stop pace of positive economic
surprises that have been in place since October may be coming to an end, marked
most recently by a disappointing March jobs report. Related to this slight shift in
economic conditions, the Federal Reserve is no longer as accommodative as it once
was. A moderation in growth data or a more aggressive Fed could prompt some
investors to adopt a more cautious approach.
Despite these near-term risks, however, we believe the long-term outlook for
equities remains constructive. Leading economic indicators in the United States
are positive. And around the world, growth appears to be solidifying, with
manufacturing activity improving, global trade levels rising and deflationary risks
diminishing. And while political risks are growing both in the U.S. and around the
world, we still think President Trump will be able to deliver on at least some of his
U.S. equities are not inexpensive by historical terms, but we still think equities look
more attractive to bonds, which appear expensive. Over the next 6 to 12 months,
we think bond yields will rise and global equity prices will appreciate. This outlook
suggests a pro-growth investment stance continues to make sense. Volatility is also
likely to rise, but we encourage investors to ride out near-term market disruptions
and focus on long-term goals.
1 Source: Morningstar Direct, as of 4/13/17
2 Source: Bureau of Labor Statistics