Promising economic data and an improving corporate earnings backdrop helped to boost equities during the first quarter. Stocks began the year on a strong note, with the S&P 500 returning over 5% for the period. The market has shown resiliency despite a turbulent political environment and incrementally tighter domestic monetary conditions. Overall, we remain cautiously optimistic that stocks can continue to move higher.
In our view, positive economic data and an inflection in corporate profits have been the main drivers behind the recent strength in the market. Both consumer and corporate sentiment are at healthy levels, as evidenced by recent purchasing manager and consumer surveys. As well, labor market indicators have been quite strong. The economy added 235,000 jobs during February according to the Bureau of Labor Statistic’s initial tally. This was well ahead of expectations for 200,000 additions. ADP, in its monthly private sector employment report, described February as an incredibly strong month with their proprietary measure of job gains coming in at 298,000, the best showing in recent years. The trend in initial unemployment claims has also been quite encouraging, as the data recently fell to a level not seen since 1973.
Corporate profits have also improved. The third quarter of last year saw an end to five consecutive quarters of year-over-year profit declines and earnings have accelerated further since then. Our expectation is that profits will continue to come in at healthy levels going forward, supported by strength from certain areas of the US economy and improving international conditions – most notably in Europe, China, and other emerging markets. We believe that the Industrial, Energy, and Materials sectors will be the primary beneficiaries of an improving global economy. This would provide a significant boost to aggregate S&P 500 earnings, given the inherently high operating leverage of many of the businesses that comprise these sectors.
In the US, politics continues to be a focal point as investors attempt to gauge the prospects for the new administration’s pro-growth policies. We have been optimistic that Trump’s economic initiatives, including tax and regulatory reforms, can be beneficial for stocks. That being said, the Trump administration’s turbulent start may have erased some of the political capital necessary to implement these measures. Specifically, the failure to repeal and replace the Affordable Care Act (ACA) raises questions for us about the passage of other key pending agenda items. However, while tax reform and fiscal stimulus will require support from legislators, the President generally has more unilateral power when it comes to regulatory reforms.
The market’s reaction following the failed bid to replace the ACA was instructive. Stocks declined the following day, but then stabilized. We take this somewhat muted reaction to be supportive of our view that the bulk of the market’s recent gains has been a function of improving economic and corporate earnings conditions, as opposed to expectations for White House driven stimulus measures and reforms. If the market’s rally had been underpinned by the latter, we believe broader declines following the halted health care initiative would have been more likely.
The Federal Reserve took action during the quarter by hiking interest rates 25 basis points at their March meeting. Despite this move, we believe markets interpreted the meeting as a dovish one on balance, primarily because the Fed’s projections for future levels of interest rates remained largely unchanged. Many investors expected an increase in projected as well as current rates. Moreover, during her comments Fed Chair Janet Yellen stressed that the Committee’s outlook has not changed, noting that the central bank’s 2% inflation target should not be viewed as a ceiling. With various inflation readings having already achieved this level, these comments were timely and further supportive of Yellen’s suggestion that the Fed’s goal for a deliberate pace of policy normalization remains in effect.
Turning to international economies, we are encouraged by recent indications out of Europe. Purchasing Managers Indices for both the manufacturing and service sectors came in at healthy levels during March, and ECB president Mario Draghi remarked that the continent’s cyclical recovery may be gaining momentum. He also suggested that risks to the economy appear to have receded. One of our key concerns here has been the populist wave which has threatened the sustainability of the European Union. In this regard, we were encouraged to see the Netherlands election result in the anti-EU candidate, Geert Wilders, failing to unseat Prime Minister Mark Rutte. We also note that in France, National Front leader Marie Le Pen has seen her polling numbers weaken in recent weeks. To be sure, lessons learned from the US presidential election and Brexit give us pause with regards to putting too much emphasis on political polls. Still, these trends may be indicative of a weakening in populist forces, and therefore at least incrementally lower the risk of a Eurozone breakup, in our view.
We have a positive outlook on stocks. As noted, we expect earnings growth to remain at healthy levels in coming quarters, aided in part by improving economic prospects, particularly in the more asset intensive sectors. We see groups of Industrial and Materials stocks, with their typically elevated fixed costs, appearing poised to generate strong profit growth should the macro environment allow for healthy sales. In addition, many other international economies are also showing positive signs. A metric which tracks the breadth of global manufacturing expansion recently notched its highest level in recent years, with nearly 8.5 out of every 10 countries currently enjoying positive output growth.
Moreover, alongside what we believe to be a constructive outlook for global growth, monetary policy in aggregate remains highly accommodative. Central banks in Europe, England, and Japan all continue to expand the size of their balance sheets, while interest rates in the US remain low by historical standards. We think that the prospects for a pickup in growth, combined with high levels of liquidity in financial markets, should allow stocks to continue to move higher.
A key risk to our outlook would be if the economy fails to pick up steam, putting pressure on corporate revenues. While certain areas of the economy are showing robust activity, others are flagging and expectations for Q1 GDP growth have dipped to approximately 1%. That said, we are not now overly concerned about a lackluster first quarter, as first quarters have consistently been slow in recent years, and growth has typically accelerated thereafter. We think it is likely that this year will follow the same pattern, particularly given the strong jobs picture and accelerating wages which could give a lift to consumption going forward.
We also continue to view the domestic political environment as a potential stock market headwind, particularly should Trump’s GOP support erode. We have posited that most of the recent market gains have been due to solid fundamentals, but we would nonetheless expect the market to react negatively to events which might derail Trump’s pro-growth agenda. While we continue to monitor this risk factor, ultimately we believe that economic fundamentals can continue to improve, even without the boost from a potential tax reform or fiscal stimulus package. This gives us some degree of comfort despite what appears likely to be a choppy political environment for the foreseeable future.
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