As Equity Prices Rise, Downside Risks Mount

Key Points

▪ Stock prices continue to rally as economic data improve and investors remain optimistic about the political backdrop.

▪ We think this optimism may be overdone and markets could be vulnerable to disappointments.

▪ Nevertheless, we have a constructive view toward equities and think a pro-growth investment stance is warranted.

U.S. equities advanced yet again last week with the S&P 500 Index climbing 0.7%.1 Economic data continued to come in better than expected. Consumer confidence reached its highest level since 2001 last month2 while the ISM non-manufacturing index, which measures business activity and employment trends, showed its strongest reading since late 2015.3 As economic data improve, the Federal Reserve indicated a higher likelihood of an interest rate increase later this month.

Potential Risks to Equities:
In lieu of our regular investment themes, we examine five possible market risks:

1. U.S. Politics: Despite growing signs of disunity between President Trump and the GOP Congress, investors still appear optimistic about prospects for pro-growth economic policies. However, we expect investors may lose patience if specifics about issues such as tax policy and health care reform are not forthcoming.

2. European Politics: Perceived risks in Europe have faded as Marine Le Pen’s standing in the French polls has dropped. But the rise of such nationalist candidates may pose a risk to economic growth and equity markets.

3. Earnings: Corporate earnings have improved over the past couple of quarters, but forward-looking expectations may be too high. Consensus expectations are for a double-digit advance in earnings growth for 2017.4 That level will be difficult to achieve, especially since profit margins remain under pressure.

4. Economic Growth: We have seen an almost uninterrupted string of positive growth surprises in the U.S. economy over the past several months. We don’t expect growth to slow, but more bumps are likely in the coming months.

5. The Fed: Investors have largely shrugged off prospects for higher rates, but rising rates could eventually dampen equity market momentum. Additionally, we see a great deal of uncertainty surrounding who Donald Trump will nominate to the Federal Reserve Board of Governors.