Stocks enjoyed a strong February, as the S&P 500 returned nearly 4% for the month. Investors were heartened by healthy domestic economic data, particularly regional manufacturing surveys which came in at robust levels. While we have some reservations regarding the turbulent political environment, we continue to believe that improving economic conditions should bode well for corporate earnings and in turn stock prices.
Various regions of the country reported robust levels of manufacturing activity. Most notably, the Federal Reserve Bank of Philadelphia’s Manufacturing Business Outlook easily surpassed expectations and came in at its strongest level since 1984. In addition, regional manufacturing surveys covering the greater New York, Chicago, Richmond, and other areas also reported healthy levels of activity. As well, the ISM’s national survey of the manufacturing sector for February surprised to the upside, with its forward looking new orders component showing particular strength. While wages decelerated slightly in January, job creation was strong with 227,000 positions added to the economy during the month. Moreover, the weekly level of unemployment claims recently hit the lowest level since 1973, a feat all the more impressive given that the population has grown by approximately 50% since then.
Inflation has been moving closer to the Federal Reserve’s targeted level in recent months. Both producer and consumer price indices have hit highs for recent years, yet continue to remain at levels we consider benign. In addition, the price index for personal consumption expenditures (PCE), the Fed’s preferred inflation reading, rose by 1.9% from the previous year in January, coming in just below the central bank’s 2% objective. Investors are often concerned with rising inflation, as it at times coincides with falling equity valuations. However, inflation has undershot expectations for several years now and we believe that despite the recent rise, it remains far from levels which could deter stocks. Moreover, in our view, there are several forces at play during the current cycle which reduce the risk of inflation rising to dangerous levels, including automation and robotics, global trade, and demographics.
Given recent economic data and inflationary readings, it is perhaps not too surprising that the Fed appears primed to raise rates. Entering February, investors were pricing in less than a 15% probability for a Fed hike at the upcoming March meeting, based on trading in federal funds futures. Market expectations began to change in recent weeks after Fed Chair Janet Yellen’s congressional testimony in which she gave a fairly upbeat assessment of the US economy. Following her testimony, several Fed officials have made public comments suggesting that a March rate hike is on the table. Investors appear to be heeding these words as market implied probabilities for a Fed move in March have shot up to 80-90% in recent days. As well, the yield on the 2-year Treasury bond, which tends to be heavily driven by expectations for Fed policy, hit 1.3%, its highest level since 2009. What we find most interesting and encouraging about this abrupt shift in expectations for monetary policy is how resilient stocks have been. Equities can be vulnerable to shifts in Fed expectations, particularly when rates are moving higher. However, in this case investors appear to be viewing this as a positive dynamic, in that the Fed sees economic fundamentals as being healthy enough to absorb multiple rate increases this year.
We maintain a constructive outlook on the market. As noted, economic data has been encouraging and we believe that should continue to bode well for corporate earnings, which are now growing again following several quarters of declines. In addition to improving economic fundamentals, policy also remains supportive of stocks, in our view. With the Federal Reserve’s desire to tighten interest rates notwithstanding, monetary policy remains decidedly in accommodative territory. Even if the Fed were to hike rates three times this year, as it currently envisions, that would still likely put the federal funds rate at less than 1.5%, quite low by historical standards. In addition, we continue to believe that the Trump administration will attempt to bolster the economy through various pro-growth initiatives, including tax and regulatory reforms.
Outside of the US, growth in key international economies has also been encouraging. February’s Eurozone Composite PMI (an aggregate reading of the services and manufacturing sectors) topped estimates while coming in at a level consistent with healthy economic expansion. Moreover, looking at the details of the report, both incoming orders and hiring were at multi-year highs, which we anticipate should bode well for future Eurozone growth.
While we hold a positive outlook on stocks, we do acknowledge that the market has moved meaningfully higher in recent months and therefore may be due for a near-term pullback. However, we are not overly concerned about this. Consolidations following periods of steady appreciation may be viewed as healthy insofar as they wring out market excesses and could pave the road ahead for more sustainable gains. A more considerable risk factor in our view is if Trump were to lose the support of the GOP, endangering his pro-growth initiatives. In this regard, we are monitoring congressional votes on various bills and nominations to help us gauge the extent to which Republicans are supporting Trump’s agenda. It appears that the president continues to have ample support from fellow Republicans at the current time.
A key question is to what extent are Trump’s stimulative initiatives already baked into stocks? Many commentators have pointed to the market’s appreciation since the election as evidence that investors are in fact pricing in quite a bit of the president’s pro-growth agenda. However, in our view economic and corporate sector fundamentals, which had been improving for months prior to the election, are the primary forces behind the market’s recent strength. We do believe that enthusiasm for Trump’s economic policies has had some impact on stock prices, but not to the same extent as economic and corporate dynamics. Therefore, while we would expect to see some dislocations in the market should Trump’s pro-growth initiatives be rebuffed, we do not think that all of the market’s post-election gains would necessarily be at risk. Nevertheless, we continue to maintain our risk-conscious approach to seeking long-term growth.
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