Healthy US corporate profits and positive international economic data helped stocks to generate modest gains in May. Markets were resilient despite continued turbulence from inside the Beltway and pronounced geopolitical tensions. While we have slightly downgraded our domestic economic outlook, we continue to believe that corporate profits will hold up well, which should help the stock market continue its ascent.
In recent weeks, the domestic economy has shown some signs of weakness. During May, a disappointing 138,000 jobs were created, and while the unemployment rate declined to 4.3%, this was primarily the result of more people exiting the labor force. Perhaps most disconcerting to investors is the dip in inflation, as recent readings have fallen to their lowest levels since late 2015. Treasury yields have been declining, likely in response to some of this tepid data, and the yield curve has also flattened. The yield premium on the 10-year Treasury relative to the 2-year sits at just 93 basis points as of this writing, down from a post-election high of 136 basis points. The yield curve does typically compress during periods when the Fed is hiking interest rates, but this current phenomenon may also be a reflection of investor concerns regarding the pace of future economic activity.
We have previously written about the potential for a monetary policy mistake should the Federal Reserve continue its tightening campaign even if economic growth were to slow. With the recent soft domestic data, we believe, however, that the Fed would change its current plans should the economy weaken. In recent speeches, multiple Fed governors have acknowledged that while a June rate hike still appears to be a near certainty, any further tightening beyond that will be data dependent.
May’s job report and CPI readings notwithstanding, we expect that the economy will continue to generate growth in line with the post-recession average. Consumer confidence remains quite healthy, and improvements in international economies, for Europe in particular, should help to boost US-based multinationals and exports. Other positive indicators include capacity utilization, which has been trending higher and is nearing the threshold which has historically led to increased corporate investment. Finally, while the preliminary first quarter reading on GDP was uninspiring, the first revision looked a bit better. Real final sales growth, which strips out the impact of changes in inventories, was revised up from 1.6% to 2.2%, a level consistent with overall GDP growth in recent years.
In Washington, the lack of progress on the Trump administration’s pro-growth initiatives has disappointed many investors. Major tax reforms and infrastructure upgrades may prove to be difficult to implement in the current political environment. Along with some of the recent tepid data, these are the main reasons why we are incrementally less bullish on the economy today compared with a few months ago. However, we do continue to believe that headway can be made with regards to deregulation, as many of these types of actions do not require legislative support.
In terms of stock market impact, we believe that much of the post-election rally has been a function of improving fundamentals, as opposed to heightened expectations for new, stimulative government policies. We believe the market’s resiliency, despite the seemingly constant news flow about possible Russian interference into the US presidential election, is supportive of this view. One final point in this regard is that both the yield curve and dollar have now given up their post-election gains. In our opinion, these shifts lend further support to the idea that capital markets have embedded low expectations for President Trump’s pro-growth initiatives. We therefore expect that markets can continue to move higher, despite the turbulent domestic political environment.
In Europe, economic fundamentals continue to improve. April’s manufacturing survey came in at a 6-year high, and May’s reading was at a level which has historically been consistent with 3% GDP growth. Consumer confidence remains strong, and in May reached its best level in a decade. Perhaps even more significant than the economic indicators are the shifting political dynamics at play. Specifically, we believe that France’s new leadership will attempt to work closely with Germany to strengthen Europe’s core via structural reforms. Moreover, we believe that Brexit and President Trump’s America First policies have had a positive, albeit unintended consequence in that they have brought closer together the countries of continental Europe. We view this as quite significant, as the potential dissolution of the Eurozone has been a major concern for investors over the last several years.
We maintain a positive bias in our market outlook. Corporate earnings have been strong, with aggregate S&P 500 profits growing approximately 14% on a year over year basis during the first quarter. Nearly 67% of companies surpassed consensus revenue estimates as overall top line growth came in at just under 8% for the period. While we would not expect to see earnings growth accelerate much further, we do anticipate that corporate profitability will remain healthy in the coming quarters.
We also see the potential for a silver lining from the Treasury yield declines. While they may be indicative of uneven growth to come, another way to view lower yields is that they are, in effect, an easing of financial conditions. They enable corporations to raise cheaper capital, and can also benefit the consumer, particularly in the housing market where mortgage rates have declined meaningfully in recent weeks. Similarly, the weakening dollar should benefit US-based multinationals, as it makes their products and services more competitive versus international peers.
Risk factors that we are monitoring include a turbulent geopolitical environment. North Korea has been conducting missile tests on a regular basis, and terrorism remains a global threat. While markets have been resilient to these types of issues, we feel that it is prudent to consider them while constructing our investment allocations. Another commonly cited investor concern is that stocks appear expensive based on valuation metrics. We agree that relative to historical averages, market multiples such as the P/E ratio do appear elevated. However, we think that valuations can not be considered in isolation, but instead should be analyzed alongside the yield environment. Relative to current bond yields, which are at very low levels, we do not see the market’s valuation as overly extended. Overall, we maintain a positive view despite these risk factors. We believe that healthy corporate earnings, an effective easing of financial conditions, and improving international economies should enable stocks to continue to move higher.
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.