Equity markets remained strong in July, as the S&P 500 returned over 2% for the month. Investors were heartened by a solid start to the second quarter earnings season. While we have concerns about the political environment in DC, the combination of healthy corporate profits and easy financial conditions keeps us optimistic on stocks moving forward.
With the majority of S&P 500 companies having reported, second quarter earnings season is shaping up to be another strong one for the corporate sector. Profits are on pace for double digit growth for the second consecutive quarter, a feat which has not been accomplished since 2011. Revenues look to be growing at approximately a 5% clip, which would mark the second best quarter for top line growth over the last five years. Moreover, the percentage of companies exceeding estimates on the revenue line, and the magnitude of the outperformance, are also coming in at multi-year bests. While some of the sales gains have been aided by a weaker dollar, we still view these results as quite impressive, and indicative of a healthy corporate sector.
The Federal Reserve in recent weeks has provided investors with more clarity on its plans to reduce the size of its massive balance sheet. Following years of increasing its assets via extraordinary policies in the wake of the financial crisis, the central bank appears ready to begin the normalization process this fall. Just as the Fed has been quite cautious with its interest rate hikes, the bank intends to proceed similarly with its balance sheet reduction, so as to minimize any potential disruption to capital markets. The current plan is to allow up to $6 billion in Treasuries and $4 billion in mortgage bonds to mature per month – up until now those maturing proceeds have been reinvested in new bonds. Over time the Fed expects to increase these amounts until its bond holdings are rolling off at an aggregate maximum of $50 billion per month. While it is possible that this process may disturb capital markets despite the central bank’s best efforts, we note the Fed is being very transparent in its communication to the investment community. Ultimately this action should be viewed positively given that Fed officials no longer believe the economy needs this type of support.
Economic growth during the second quarter accelerated to an annualized pace of 2.6%. While this was a significant uptick from the prior quarter’s 1.2% growth rate, given the issues in recent years with first quarter seasonality, we think it may be more instructive to look at the aggregate first half growth rate, which came in at 1.9%. This performance is consistent with the 2% type growth which has persisted over the last several years. Our forecast for the economy is that it is likely to continue to grow in line with its post-recession trend for the foreseeable future, and we see little in this most recent GDP report to change our view.
We maintain our positive view of the market, and believe that the combination of low interest rates along with healthy corporate profit growth provides plenty of support to justify current equity valuations. While interest rates may be moving higher in the future, with the Federal Reserve and other central banks seeking to normalize monetary policies, we continue to view aggregate financial conditions as being accommodative. In this regard, the Goldman Sachs Financial Conditions Index, based on factors including bond yields, the dollar, and stock prices, recently hit its lowest level in over 2.5 years. In addition, while investors have by and large been disappointed by the Trump administration’s lack of progress on many of its pro-growth initiatives, there has been movement on regulatory reform. We believe there is a lot more than can be done in this regard, and further efforts could provide a tailwind to a wide range of industries.
The unstable domestic political environment is a key risk factor in our view, particularly given that officials will have to manage both the debt ceiling and enact a federal budget in the coming months. Should politics interfere in either endeavor, the US could be at risk for a debt default or a government shutdown. Moreover, these issues will have to be dealt with during the September/October timeframe, which has historically been the weakest period for the market. Typically with this type of uncertainty, we would expect to see a strengthening dollar, widening corporate bond spreads, and increased stock correlations. Currently none of these indicators are flashing warning signs. We will continue to closely monitor them, cognizant that the potential combination of political headlines and initiation of the Fed’s balance sheet unwinding process could create volatility in the market.
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