Key Points
▪ Third quarter earnings started off poorly, dragging down equity market sentiment.
▪ We expect earnings results to improve over the coming quarters, which should act as a tailwind for equities.
▪ Investors face a number of risks, but we advocate a cautiously pro-growth investment stance.
U.S. equities retreated last week, with the S&P 500 Index declining 1.0%.1 Sentiment was dragged down by negative earnings updates, a disappointing trade report from China and rising U.S. political turmoil. For the week, defensive and yield-generating sectors outperformed, while materials and health care lagged.1
Weekly Top Themes
1. Equities may struggle until corporate earnings improve. For the past 18 months, equities have been able to make modest gains despite declining corporate profits. This has largely been due to highly accommodative monetary policy and central banks’ willingness to engage in new easing measures. Additionally, investors have been willing to look past the earnings recession since we have not seen a corresponding economic recession. Looking ahead, we believe earnings must advance for equity markets to make meaningful gains. It is early in the third quarter reporting season, but so far the news hasn’t been favorable.
2. It may take another quarter before corporate earnings accelerate. At present, consensus expectations are that earnings will decline 3% in the third quarter while revenues rise 3%.2 Excluding energy, earnings would be up 1% with revenues advancing 4%.2 Conditions should improve in the fourth quarter, with consensus expectations pointing to a 6% earnings increase.2
3. The minutes from the September Federal Reserve meeting indicate a December rate increase is likely. The minutes also showed that the decision not to raise rates last month was a close call.
4. The U.S. economy is unlikely to sink into recession, but remains vulnerable. With nominal gross domestic product growth so low (it has been averaging around 3% this year),3 the economy could falter if we see a sharp oil price increase, a spike in bond yields, escalating political uncertainty or other shocks.
5. Equity markets may react more positively to divided government. At this juncture, it looks likely that Hillary Clinton will be elected president. The Senate appears up for grabs, which makes the House of Representatives key. We expect the House to remain in GOP hands, but if Democrats take control we would likely see a minimum wage increase, tax increases and further regulations in the health care and financial services industries. Such events would likely trigger additional economic and market uncertainty.
Despite Many Positives, Anxiety Remains High
While investors have focused on an increasingly contentious U.S. political backdrop, the global economy has been reasonably solid. Brexit spillover has not affected the rest of Europe, Chinese growth has remained relatively stable and the United States has been slowly accelerating.
Despite a reasonably decent backdrop, investors have been cautious and unwilling to take on more risk in their portfolios in recent years. This wariness is understandable given the high number of shocks occurring in this cycle, including the sharp collapse in commodity prices, the Greek debt crisis, China devaluing its currency, Brexit, widespread terrorism, geopolitical uncertainty and a fractious U.S. political backdrop.
As a result, stock prices have been trapped in a relatively volatile trading range, moving only slightly higher since the beginning of 2015. Looking ahead, we think the macro backdrop should be conducive for better equity performance. Global growth remains solid and corporate earnings should recover in the coming quarters.
For these trends to translate into firmer equity prices, investors must believe the global economic recovery and earnings cycles will become self-sustaining, meaning that equities will no longer be dependent on monetary policy stimulus. While we remain cognizant of all of these risks, we nevertheless advocate retaining a progrowth but cautious investment stance.
1 Source: Morningstar Direct, as of 10/14/16
2 Source: Bernstein Research
3 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. 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 priceweighted 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. 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. Bloomberg 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.
RISKS AND OTHER IMPORTANT CONSIDERATIONS
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. Non-investment-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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