Key Points
▪ U.S. economic growth is improving, but this expansion remains anemic compared to previous cycles.
▪ We anticipate modest, if uneven, improvements in corporate earnings, which should help equity prices.
▪ A rising protectionist, anti-globalization wave could be a negative for the economy and financial markets.
U.S. equities climbed once again last week thanks to a Friday rally. The S&P 500 Index climbed 0.2% for the week.1 The first presidential debate dominated discussion early in the week, and investors focused on what Deutsche Bank’s capitalization issues could mean for the global banking system. OPEC announced preliminary plans to cut production, which drove up oil prices. The energy sector was the strongest performer last week, while defensive sectors underperformed.1
Weekly Top Themes
1. U.S. gross domestic product growth appears to be improving modestly. Second quarter growth was revised higher last week from 1.1% to 1.4%.2 Based on the economic data we have seen to date, we expect third quarter growth to climb to between 2.5% and 3%, with consumer spending rising more than 3%. Friday’s payroll report will be key to the outlook.
2. OPEC’s decision should help prevent another near-term collapse in oil prices. Details are vague and skepticism over exactly how OPEC’s production cuts will occur is warranted, but the decision to cut production by 200,000 to 700,000 barrels-per-day is significant. Increased odds of oil price stability are positive for both the global economy and financial system.
3. Slow growth and low inflation have created a weak economic expansion. Since the current recovery began in 2009, nominal U.S. GDP growth has averaged only 3.3%, compared to 5.3% during the last expansion.3 Low levels of credit growth, deleveraging, slow productivity growth, tight lending standards and the need for structural reforms suggest these trends may persist.
4. Corporate earnings may continue to struggle. Slow economic growth and deflationary concerns have put downward pressure on corporate earnings over the past eighteen months. These factors remain concerns, but we are seeing signs that earnings may improve. Nevertheless, it will be an uphill road for many areas of the market.
5. Profits are also under pressure. Poor pricing power conditions and rising labor costs will likely complicate an already difficult corporate earnings environment. Uneven profits and earnings trends make the need for investment selectivity critically important.
Slowing Global Trade Represents an Economic and Financial Risk
At this juncture, we think it makes sense to retain a pro-growth, pro-risk investment stance and believe that equities are better positioned than bonds or cash. We need additional clarity surrounding U.S. economic policy (which should come after the elections), and are closely watching the European banking system for signs of instability. On the positive side, we believe business confidence is strengthening, labor trends are positive and consumer spending should improve. This should help the U.S. economy accelerate modestly over the coming year. Government bond yields are exceptionally low, and we think it would take a significant deflation scare to push them lower, which we think is unlikely. As such, we anticipate government bonds will struggle to post positive returns in the coming quarters. Equities, in contrast, should experience modest tailwinds from improving economic growth and greater stability in commodities prices.
The key for equities remains corporate earnings. Headwinds for earnings certainly exist, but a combination of rising spending levels, improving business confidence and the fading of the twin oil/dollar drags suggest the earnings recession is ending.
The weak link for the global economy is trade. So far, improvements in U.S. and eurozone growth have not translated into an uptrend in global trade levels. Trade levels have been held back by weak demand in many countries, low levels of business investment, rising inventories and falling goods prices. More worrisome than these fundamental factors, however, is a shifting political environment in many countries toward a more domestically-focused, anti-globalization stance. If this triggers a protectionist spiral that causes new trade barriers, we think it would be a detriment to corporate profits, global economic activity and financial markets.
1 Source: Morningstar Direct, as of 9/30/16
2 Source: Bureau of Economic Analysis
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. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. The Russell 2000 Index measures the performance approximately 2,000 small cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. Euro Stoxx 50 is an index of 50 of the largest and most liquid stocks of companies in the eurozone.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. 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. MSCI EAFE Index is a free float-adjusted market capitalization weighted index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is an unmanaged market index of U.S. Treasury securities maturing in 90 days that assumes reinvestment of all income.
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