Stocks enjoyed a strong October, as the S&P 500 advanced over 8% for the month. Markets reacted well to positive news coming out of Europe and China. While we maintain a balanced outlook on equities, we question how much near-term upside remains following this most recent run-up.
China’s economic deceleration has been a major concern for investors over the last several months. While the recent spate of data has been mixed, we believe that alongside further stimulative policy actions, nascent signs of stabilization were enough to alleviate some of these fears. Examples of better than expected data include retail sales which grew by 10.9%, and industrial profits which fell by just 0.1% during September, a significant improvement from August’s 8.8% decline. Meanwhile, the People’s Bank of China again cut benchmark interest rates and lowered bank reserve rate requirements in attempts to reinvigorate economic activity and lending. It appears that similar actions taken in recent months may have started to gain some traction, as Chinese bank credit creation in September came in at 1.05 trillion yuan, a meaningful increase over the 810 billion yuan lent during August.
In Europe, Mario Draghi, president of the ECB, made news by intimating that he was prepared to take further steps in order to bolster the economy. The ECB already has a quantitative easing program in place, through which it is purchasing 60 billion euros per month of (primarily) government bonds. It also has implemented a negative deposit rate in order to encourage banks to increase lending. Draghi suggested the possibility of expanding the bond purchase program and lowering the deposit rate further into negative territory, perhaps as early as December. Capital markets appeared to respond favorably to these dovish remarks, as the euro weakened versus the dollar and European stocks advanced sharply on the day.
With regards to domestic monetary policy, the Federal Reserve recently indicated that it is prepared to raise rates at its upcoming December meeting, should economic conditions warrant such a move. Moreover, in the policy statement accompanying its October meeting, language was removed regarding certain global developments acting as headwinds for the U.S. economy. We believe that many market participants have taken the Fed’s reluctance to raise rates as a negative indicator, because it suggests a lack of confidence in the health of the economy. We therefore view these most recent hawkish comments as positive for markets, and believe that while there may be an adjustment period following the initial rate hike, ultimately it will be beneficial for stocks to move past this period of uncertainty.
Turning to the corporate sector, we have been disappointed with third quarter earnings. With just over two-thirds of S&P 500 companies having reported as of this writing, both aggregate earnings and revenues are on pace for mid-single digit declines, one of the worst showings in recent years. Moreover, we note that many stocks have seen outsized moves on earnings, which has been another source of volatility in the market. We see these results as perhaps not all that surprising, given that GDP decelerated sharply during the quarter to a 1.5% annualized pace. However, we believe that this slowdown was largely a result of a normalization of inventories, which had become bloated during the first half of the year. We do not expect this headwind to persist into next year, and note that final demand (excluding inventory accumulation) grew at a reasonably healthy 3% clip during the quarter—a positive sign going forward in our view.
We maintain a balanced view on the stock market. Despite some better than expected data of late, concerns regarding China’s slowdown remain valid, in our view. In the U.S., we are starting to see some evidence of wage inflation in certain sectors of the economy. While this may be a positive for consumption, cost pressures in a muted top line environment could pose a challenge for the corporate sector. We also note that in the wake of the strong October rally, stock valuations have moved back towards levels that are ahead of historical averages. We therefore wonder whether the market’s strong October performance may have been the year-end rally that some investors were anticipating.
Factors that we see as supportive of equities and keep us from taking a bearish view include accommodative monetary policy globally, which is still quite supportive in aggregate. Although we are hard pressed to make the case for substantial corporate earnings growth next year, we do not expect the economy to decelerate below its post-recession trend, which we believe will allow corporations to show at least some year over year profit gains. Finally, we were heartened to see progress made with regards to a budget deal, and see this as removing a potentially significant headwind for capital markets. As always, we remain committed to seeking growth over the long term by investing with a risk-conscious approach.
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