▪ Equities trended sideways last week as investors appear to be waiting to see how some near-term risks shake out.
▪ There are legitimate reasons for concern, but we expect the global economy to gradually improve over the coming year.
▪ Corporate profits should strengthen in 2016, pushing equity prices higher.
U.S. markets were relatively quiet last week due to the Thanksgiving holiday. Economic data were generally positive and investors seemed less concerned about increasing evidence that the Federal Reserve will raise rates at its policy meeting in December. The S&P 500 Index was up fractionally for the week.1 Smaller capitalization stocks outperformed, as did the consumer staples and energy sectors.1 Outside of the United States, Chinese stocks sold off sharply on Friday as investors grew nervous about policymakers’ latest attempts to regulate the Chinese brokerage industry.1 Oil prices rose slightly and the U.S. dollar advanced against other currencies.1
Weekly Top Themes
1. Third quarter gross domestic profit growth was revised higher. The latest reading showed that the economy grew by a 2.1% annualized pace last quarter, rather than the 1.5% rate earlier reported.2 Final real sales were revised lower, while inventory levels were revised higher.2
2. Corporate profits fell in the third quarter. Profits levels ticked down on a quarter-over-quarter basis and are below their 2014 level.3 Most of the weakness was due to poor profits in the financial sector and in non-U.S.-derived profits.3
3. Importantly, domestic nonfinancial profits remain strong. Domestic nonfinancial profits are three times larger than financial profits and twice as large as non-U.S. profits.3 Looking ahead, we think this area of the corporate sector will continue to be strong. Restrained unit labor costs, the strength in the U.S. dollar, solid consumer spending levels and housing and health care spending are all tailwinds for domestic nonfinancial sectors.
4. Investor sentiment remains constrained, and many fear upside for equities is limited. After a bull market that has lasted six-and-a-half years, such concerns are understandable, and we expect equities will continue to trade within their current trading range. An upside breakout will likely require better corporate results coming from more pricing power and an increase in productivity. We expect we may see these themes emerge in 2016.
Near-Term Risks Remain but Should Diminish Over Time
Investors and financial markets seem stuck in a holding pattern, waiting to see how a number of near-term risks shake out. The renewed strength of the U.S. dollar is causing some angst, especially since pending Fed rate hikes may put additional upward pressure on the currency. China’s precarious economy is also much in focus. Despite some signs of stability over the past couple of months, weakening growth has led to lower commodity prices, which have hurt emerging market economies. And broad fears of deflation and renewed recession still linger in pockets around the world, although core inflation in developed markets appears to be creeping higher.
None of these issues can be easily dismissed, but we believe these risks should remain contained. Overall, we expect the world economy to avoid widespread recession and experience improved growth levels. Policymakers in China are highly attuned to promoting growth and supporting domestic demand. Europe remains another risk, especially since we may see some negative effects from the Paris terrorist attacks. However, overall economic momentum remains positive. The strength in the dollar is a negative for overall U.S. corporate profits, and this headwind may well persist into next year. Yet we doubt we will see a repeat of the degrees of upward movement in for the dollar we witnessed over the last 18 months.
So what about Fed policy? It is possible investors will view the first rate increase as a negative, believing the Fed acted prematurely and is putting a fragile recovery at risk. Or, investors could view the move as an acknowledgement that the economy is strong enough to warrant higher rates and breathe a sigh of relief that the will-theyor-won’t-they drama is finally over. We think the latter outcome is more likely.
As a result of these views, we suggest maintaining a pro-growth investment bias. Government bonds appear unattractive, and are likely to come under pressure if and when economic growth accelerates. We are banking on improved corporate profits in 2016 and expect interest rates to rise modestly and gradually over the coming year. Equities should do relatively well in such an environment.
1 Source: Morningstar Direct and Bloomberg, as of 11/27/15
2 Source: Commerce Department
3 Source: Cornerstone Macro
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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