Stocks enjoyed a solid second quarter, as the S&P 500 rose 3.1% for the period. Improving economic conditions internationally and strong US corporate earnings helped to offset concerns surrounding stubbornly low domestic inflation and a flattening yield curve. Looking ahead, we maintain our cautious optimism on the stock market as we expect healthy corporate profits and easing financial conditions to enable equities to continue to move higher.
Improving European economic and political conditions have been among the most important developments of the year thus far. Coming into the year, we considered European politics to be a key risk factor for global capital markets, as a populist wave appeared to be gaining strength across much of the continent and investors were concerned about the long-term sustainability of the Eurozone. More recently, the tides have seemingly begun to turn. Investors cheered Emanuel Macron’s defeat of the staunchly nationalistic Marine Le Pen in the French presidential elections. As well, German Chancellor Angela Merkel has signaled a willingness to reconcile key differences with France concerning the governance of the Eurozone. Merkel noted that under certain conditions, she may support France’s call for a Eurozone finance minister as well as a common budget. Mario Draghi, president of the European Central Bank, noted in a recent speech that “Political winds are becoming tailwinds. There is newfound confidence in the reform process and newfound support for European cohesion, which could help unleash pent-up demand and investment.” We agree with these comments, and as a result believe that one of the biggest threats to global capital markets coming into the year may now actually turn out to be a source of upside.
Economic conditions in Europe have also improved. Both consumer and business confidence are at multi-year bests, and manufacturing sector surveys have been strong. GDP advanced by 2.3% during the first quarter, and the fourth quarter’s growth was recently revised up from 1.9% to 2.1%. While these numbers in the absolute might not appear impressive, they are quite healthy relative to average growth levels in recent years. As noted, ECB president Draghi appeared sanguine in his assessment of the economy. He was confident that the ECB’s monetary policies have been effective, and went so far as to say that “the threat of deflation is gone and reflationary forces are at play.”
Another key development that we have been monitoring is the flattening yield curve. This is not unusual during periods of Federal Reserve tightening; however, the magnitude of the decline suggests that other factors are also contributing. We believe that lackluster US economic data have been among these factors. The Citigroup US economic surprise index, which measures incoming data compared to consensus forecasts, recently hit its lowest level since 2011, indicating that the economy has been steadily underperforming expectations.
Among the recent disappointing data, we believe that inflation has been of particular concern to investors. We see several factors weighing on inflation which could potentially persist for some time. In recent years, the US wireless industry has experienced fierce competition on pricing, and this intensified during the first half of 2017. The pharmaceutical industry too, has begun to act more cautiously with regards to pricing, as companies have chosen to self-police in an effort to head off potentially onerous government regulations. In addition, oil prices have been weakening, due in part to a lack of OPEC coordination and persistently high inventory levels. Finally, we believe that the secular growth of e-commerce has been a significant factor in dragging down consumer prices, and likely will be for some time to come.
While we are concerned that low levels of inflation may persist, we do not expect that this will necessarily lead to broad stock market declines. In short, while outright deflation does typically portend poorly for equities, we believe that stocks can still work in a disinflationary environment. Low growth and low inflation could make secular growers and dividend stocks more attractive. Moreover, companies may be able to continue hiring at a decent pace without seeing the significant wage gains typically associated with low unemployment levels which could pressure profit margins. A final consideration which we have written about in recent months is that the net effect of many of these factors is an easing of financial conditions. While low growth and disinflation can create capital market dislocations, in this case we are optimistic that the resulting lower interest rates and weakening dollar will enable US based corporations to obtain cheaper financing and to better compete in international markets.
We continue to have a favorable view on stocks. Corporate profits are coming off of an excellent first quarter, and while further earnings acceleration may be unlikely, we expect that profit growth will remain healthy. While we are not forecasting strong wage growth, we do expect solid job gains, which along with strong levels of consumer confidence may help to support economic activity.
Another positive factor supporting our outlook is the convergence of global monetary policies. In recent years, the Federal Reserve and the ECB – arguably the world’s two most influential central banks – have been on divergent paths, with the Fed having already started to increase rates while the ECB has remained firmly accommodative. In our view, this type of divergence can cause increased volatility in capital markets, and we are therefore encouraged that based on Draghi’s remarks, it appears that Fed and ECB policies are coming into closer alignment. Contrary to the assumption that tighter monetary policy must hurt stocks, we believe it can be supportive insofar as it demonstrates that policy makers have confidence in the health of their economies, assuming that rate hikes are not carried out too aggressively.
With a new administration in the White House, much investor attention has been focused on politics. A commonly cited risk factor has been the lack of progress on Trump’s pro-growth agenda, and its possible impact on stocks. We maintain our opinion that the post-election gains have been primarily a function of improved fundamentals, and do not therefore view this as a key risk factor. We are not surprised that, given the strength in corporate earnings, stocks have moved higher. A look at the performance of the dollar and yield curve, both of which have declined to pre-election levels, also suggests that capital markets have modest expectations for pro-growth legislation.
Key risks for stocks, in our view, include the potential for economic conditions to deteriorate. If GDP does not bounce back from a lackluster first quarter, it would be difficult for corporations to meet earnings expectations. That being said, despite the recent mixed data, we continue to expect that the economy will grow at a rate consistent with recent years. This is a low hurdle, but we think that it would be enough to meet investor expectations and keep corporate profits at healthy levels. However, should weak oil prices decline materially from current levels, this could derail stocks. This was the case early last year, and we believe that if oil were to break much below $40 per barrel, we could again see the aggressive production curtailments that could concern investors. Politically, we continue to have concerns about the potential for new restrictions on trade, given Trump’s America first policies. We expect that overly stringent controls would negatively impact the economy, and therefore we continue to closely monitor this situation. Overall, despite these risk factors, we maintain a positive view on the market.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.