Key Points
▪ Third-quarter earnings started strong. Should this persist, it may mark the end of the earnings recession.
▪ It looks likely that Hillary Clinton will win the presidency while the House remains in GOP hands.
▪ Equity markets face near-term pressures, but the economic and earnings environment should provide tailwinds.
U.S. equities moved slightly higher last week, with the S&P 500 Index climbing 0.4%.1 Corporate earnings results were solid, while data showed economic stabilization in China. Investors also reacted positively to high-profile mergerand-acquisition news. For the week, the materials, financials, consumer discretionary and technology sectors advanced while telecommunications, industrials and consumer staples lagged.1
Weekly Top Themes
1. Third quarter earnings results have been surprisingly strong. With more than 25% of S&P 500 companies reporting, earnings are beating expectations by 7% and revenues by 1%.2 Should these patterns hold, it will mark the end of the earnings recession largely caused by the rising dollar/falling oil trends.
2. Investors appear overly complacent about inflation. Economic growth is accelerating modestly, major central banks are becoming less accommodative and government spending is rising. These trends suggest we should see an uptick in inflation. A continued increase could put more pressure on the Federal Reserve and act as a headwind for bonds and equity valuations.
3. Defensive, yield-oriented equity sectors appear unattractive. Sectors such as utilities and telecommunications sharply underperformed in the third quarter as bond yields started to rise.1 We think these sort of bond-market proxies continue to look expensive and expect a continued shift toward economically sensitive cyclical sectors.
4. Infrastructure spending will likely increase in 2017. It appears increasingly likely that Hillary Clinton will be elected president, and we think she will soon focus on a fiscal stimulus plan that emphasizes infrastructure. Republicans in Congress may support this effort, especially if it is packaged with corporate tax reform centered on repatriated earnings.
5. Rising bond yields may limit prospects for a year-end equity rally. We do not expect a notable drop in prices over the next couple of months, but we believe any significant upside might be limited. Interest Rates and Bond Yields May Advance Modestly The presidential debates are over and election season is hitting the home stretch. Barring a massive shock, we think Hillary Clinton will likely be elected president, while the House remains in Republican hands. The Senate appears up for grabs. This environment would represent a more-or-less continuation of the status quo. Such a political backdrop would likely allow the economy to maintain momentum and the Fed to slowly raise rates. In the financial markets, this would represent a modest headwind for bonds and a tailwind for the U.S. dollar. If the Democratic party’s momentum accelerates and results in a complete change of control over Congress, this could raise uncertainty and create a more difficult environment for the economy and markets.
Investors are also closely watching the Fed. We think the Fed will very likely raise rates for the second time this cycle in December. The Fed will likely remain cautious into 2017, but it could become slightly more aggressive if and when inflation begins clearly accelerating. While many parts of the world still deal with deflationary pressures, that is not the case in the United States. The longer the economy stays on track and generates employment gains and rising wages, additional rate increases will become inevitable.
For equities, there is a growing sense among many investors that valuations are becoming expensive and stocks might be due for a correction. We think rising yields could pressure equity prices, but we do not expect a prolonged or sharp equity market decline. Economic pessimism is high and investors maintain high levels of cash. This does not indicate a peak in equity prices. Likewise, technical indicators do not signal a near-term end to the bull market (for example, high yield spreads are continuing to fall).1 We think equities may be mildly overbought following the uptrend since the post-Brexit selloff. We could see a near-term pause or mild correction, but an improving economy and brightening earnings and profits are solid long-term signals for stocks.
1 Source: Morningstar Direct and Bloomberg, as of 10/21/16
2 Source: RBC Capital Markets
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. 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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