Economic and Earnings Growth Appear Poised to Move Higher
U.S. equities were fairly volatile last week as investors focused on potential Federal Reserve action and concerns over Greece’s debt problems resurfaced. Merger and acquisition activity also gathered headlines in the technology and health care sectors. For the week, the S&P 500 Index lost 0.8%, with the energy sector declining the most and the health care, utilities and technology sectors faring the best.1
Key Points
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Economic growth experienced a rough patch in the first quarter, but we believe signs point to a rebound in the months ahead.
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Earnings growth should also accelerate, providing a tailwind for equities.
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Fed rate hikes may cause some sort of correction, but we would advise investors to ride out volatility and stick with equities.
U.S. and Global Economic Growth Should Rebound
In 2014, severe winter weather triggered a downturn in first quarter economic growth before a consumer-led rebound helped the economy reaccelerate. This year, we may be witnessing the same pattern.
Last week, first quarter gross domestic product growth was revised lower to -0.7%, driven mainly by trade and inventories.2 Looking ahead, we believe conditions are set to improve and expect the consumer sector to again lead the way. An improving jobs market, preliminary signs of wage acceleration and still-low gasoline prices should push consumer spending higher. Additionally, we expect the labor market’s contribution to the economy to grow. Also, the fact that the yield curve is not inverted is a sign that the economy should continue to accelerate.
The consumer sector of the economy weakened slightly earlier this year, but we expect that will prove to be a temporary setback. Rising confidence and higher levels of spending should help the economy shift into a higher gear. Overall, we believe the shocks from the first quarter will fade and the U.S. economy should average around 3% growth in 2015.
Outside of the United States, we believe conditions will continue to improve. The decline in oil prices and interest rates that occurred during 2014 appear to be affecting growth positively, and Europe (which has long been a pain point) is finally getting on track. Notwithstanding areas of weakness, especially in China, we believe global economic growth should advance over the rest of this year and into 2016.
Equities May Stumble, but Should Push Higher
Improving U.S. and global growth are positives for equities, but there are some caution signs investors should consider. First, we think it will be difficult for equities to make meaningful advances unless and until the earnings backdrop improves. Earnings expectations were revised sharply lower earlier this year, but we think that trend should be changing. As economic growth improves, earnings expectations should rise as well. This should help stock prices break out of the trading ranges in which they have remained for quite some time.
An additional consideration for investors is, of course, the likelihood that the Fed will be raising rates later this year. When discussing the contraction in first-quarter growth, Fed Chair Janet Yellen used the term, “transitory,” indicating she expects growth to pick up in the coming months. That backdrop, combined with some signs of inflation, suggests that the Fed will indeed be raising rates. We think September is the most likely timeframe for a starting point.
As the Fed approaches liftoff and in the months that follow, we think there is a strong possibility that equities could experience some type of selloff or correction as investors become increasingly nervous about how higher rates will affect the economy and financial markets.
Equity valuations have become moderately expensive as share prices have continued to intermittently advance. Elevated valuations increase the risk that interest rate hikes will cause a valuation “derating” and the corresponding drop in prices. This occurred during the rate hike cycles of 1994 and 2004. In our view, however, the combination of improving economic growth and recovering earnings means any correction should be short lived and modest. Moreover, the Fed has been clear that it will remain sensitive to economic and financial conditions and will move carefully and slowly as it pushes rates higher.
Investors may be tempted to try to time a potential correction, but we would advise against such strategies. We suggest a more prudent course would be to maintain overweight exposures to equity markets, ride out any volatility and continue to maintain a pro-growth investment stance.
1 Source: Morningstar Direct, as of 5/29/15
2 Source: Bureau of Economic Analysis
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Euro STOXX 50 Index is Europe’s leading Blue-chip index for the Eurozone and covers 50 stocks from 12 Eurozone countries. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. FTSE MIB Index is an index of the 40 most liquid and capitalized stocks listed on the Borsa Italiana. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The MSCI World Index ex-U.S. is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets minus the United States. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
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The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Noninvestment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results.
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