Key Points
- Earnings season has been solid and equity indexes continue to set record highs. The bull market should continue but the risk of a "melt-up" appears to be rising.
- The U.S. economy is growing modestly and the Federal Reserve is maintaining its slow pace of policy normalization—both supports for further equity market gains, but geopolitical risk remains elevated.
- While the weaker U.S. dollar is a benefit for U.S. companies, there is a downside internationally … but it may not be where you think.
What, me worry?
U.S. equity indexes continue to post record highs and the proverbial "wall of worry" appears to be losing bricks. The high expectations for earnings season have largely been bested, the U.S. economy continues to trend in a "Goldilocks" zone—not too hot, nor too cold—the Federal Reserve shows little interest in pricking any perceived asset bubbles; and despite political rancor, consumer and business confidence remains elevated—what could go wrong?
Volatility near record lows
Source: FactSet, Chicago Board of Trade. As of July 31, 2017.
Of course there are always "black swan" events that could occur—one-off events that are unknowable and unpredictable—such as a natural disaster or sudden geopolitical crisis. We don't want to be the parents who stop the music and take away the punch bowl, but the risk of a melt-up appears to be growing and we believe a decent-sized pullback in the near future would help alleviate some of these pressures. Sentiment indexes such as the Ned Davis Research Crowd Sentiment Poll indicate investor optimism has gotten extended. In keeping with excess optimism, we're getting into rarified air in terms of the amount of time since the last 5% pullback. Only three time periods in history were longer than the current span over the past 50 years. Even the headlines coming out of Washington are having little impact on sentiment as stocks keep rising and investors and consumers remain confident.
Consumers continue to feel good
Source: FactSet, Conference Board. As of July 31, 2017.
We still believe a near-term pullback is possible, but are becoming concerned about a possible melt-up, which typically ends with a commensurately harder fall. We continue to urge investors to maintain a diversified portfolio and rebalance as necessary around longer-term strategic targets. For those investors who follow our tactical recommendations, we are currently recommending a neutral (in line with strategic targets) stance for all three of the major equity asset classes—U.S., developed international and emerging markets. Within the U.S. equity market, we continue to suggest a bias toward large cap stocks over small caps cap.
Earnings looking good, while economy trudges along
Part of the reason for the tactical positioning we are recommending has been the drop in the U.S. dollar. A falling U.S. dollar can help those companies that have sales overseas and have likely helped to boost results for the larger-cap and more globally-oriented S&P 500 in this reporting period.
Falling dollar helps to boost overseas revenue
Source: FactSet, Intercontinental Exchange. As of July 31, 2017.
Second quarter earnings season started with high expectations and a relatively low preannouncement ratio of companies warning before the results were released. This has typically led to choppy market behavior, particularly if the expectations bar ends up being set too high. So far, the market has generally cheered earnings results—according to Thomson Reuters, through August 2, 72% of S&P 500 companies having reported have beaten earnings estimates, while 69% have beaten revenue estimates. The latter is encouraging as sales are much more difficult to manipulate.
Additionally, we are seeing signs of changing corporate behavior which could translate into better economic growth. According to Ned Davis Research, between the first quarter of 2016 and the first quarter of 2017, repurchases and debt issuance have both dropped, while net investments and capital expenditures have risen—both signs that companies are finally putting money to work. We believe companies will continue to spend money on improving efficiency and productivity as the labor market remains extremely tight. That tightness was reiterated by the July payroll report that showed a better-than-expected 209,000 jobs were added and the unemployment rate fell to a 16-year low 4.3%.
Low unemployment is helping fuel corporate spending
Source: FactSet, U.S. Dept. of Labor. As of Aug. 4, 2017.
Continued improvement in corporate spending could help to keep economic growth close to the 2.6% annualized gross domestic product (GDP) growth reported by the Bureau of Economic Analysis second quarter, rather than the downwardly-revised 1.2% in the first quarter. Another positive sign, and likely helped by the weaker dollar, has been the rebound in commodity prices, indicating improving global growth.
Rise in copper and iron could bode well for global growth
Source: FactSet, Commodity Research Bureau. As of July 31, 2017. China import Iron Ore Fines 62% FE spot.
Meanwhile … in Washington
The relatively optimistic picture painted above has been largely unscathed to date by the mess that is Washington. Efforts to address the Affordable Care Act—which both sides admit needs some work—have been almost laughable if it wasn't so serious; and have thrown into question the ability of anything getting done in Washington in the foreseeable future, including tax reform and infrastructure spending. Immediately ahead is the debt ceiling, which again needs to be extended. This relatively pointless number (when has it ever limited debt?) can nonetheless cause angst and volatility if it doesn't get raised in a timely manner—and that time is approaching quickly. The Congressional Budget Office (CBO) now estimates that Treasury might risk defaulting on some payments in the first half of October. We believe the ceiling will ultimately get raised before damage is done but likely not before threats and warnings that investors to date have largely ignored.
But despite the fact the Trump administration has yet to have a significant legislative achievement, its impact on the regulatory environment—where the President can act more autonomously—has been notable and to the benefit of businesses and their leaders' confidence. For example, according to Cornerstone Research, the Office of Information and Regulatory Affairs announced that it was withdrawing 469 pending rules, and removing from action another 391. This reduction in the regulatory burden may have a beneficial impact on productivity as fewer dollars are needed to comply with confusing and burdensome regulations.
Meanwhile, the Federal Reserve continues its slow and steady approach to monetary policy normalization; leaving interest rates steady at its latest meeting, but hinting strongly that the winding down of the Fed’s balance sheet will likely begin in September (see Liz Ann’s Fed Keeps it on the QT for more). Investors shouldn't be complacent about the Fed, however. With the labor market tight, and commodity prices rising, inflation could start to flare up. At the same time, the Fed is sailing uncharted waters as it begins quantitative tightening (QT) by shrinking its behemoth $4.5 trillion balance sheet.
Downside to the U.S. dollar's decline?
As noted, the weaker U.S. dollar has aided U.S. companies which have international operations. However, there are two sides to a trade—a winner and "loser." The sharp and ongoing rise in the euro versus the dollar has turned the 5% gain this year for the Europe STOXX 600 index into an 18% gain when measured in dollars, nearly doubling the 10% rise in the S&P 500. While this outperformance has been welcomed by investors in international stocks, the downside of a stronger currency for European companies is that it could mean weaker reported earnings growth as sales in foreign currency translate into fewer euros. For example, $100 of sales at the beginning of this year was worth 96.1 euros, but as of the end of July it was worth only 83.4 euros—a 13% decline for the same dollar amount of sales.
Fortunately, the stronger euro doesn't seem to be weighing on profit growth for companies in the region. Profits are rising thanks to sales to the United States making up only 16% of the total for the companies in the MSCI Euro Index; and most sales coming from within Europe where economic growth has been solid, as you can see in the chart below.
Eurozone company sales have relatively small dollar exposure
Source: Charles Schwab, Factset data as of 8/2/2017.
In fact, a stronger euro hasn't led to weaker profits for European companies since the inception of the euro as a currency in 1998, as you can see in the random scatter of dots in the chart below. So there may be little need for fear that the profit recovery in Europe will be wiped out by the recent strength in the euro.
European company earnings growth has shown little correlation with moves in the euro
Source: Factset, MSCI 7/31/2017. Monthly readings beginning January 1998. Horizontal axis limited to 100% in both directions.
The weaker dollar has made the list of what business leaders are talking about on earnings calls, but only 1% of companies that have reported so far have mentioned it. So what are business leaders talking about? Profits, not politics. Of the 721 global companies that have reported earnings results in the past month, 63% talked about higher earnings while only 3% mentioned President Trump.
What are business leaders talking about?
Source: Factset as of 8/1/2017. Based on 721 transcripts of earnings calls in the past month by companies in MSCI AC World Index.
The chart above may present a good way to think about why stocks are up this year. The positives outpace the negative topics by a wide margin. Not that all of these are negatives; certainly President Trump's policies hold both positive and negative potential outcomes for businesses, and even North Korea was mentioned favorably by one Asian company as a source of sales growth.
So what?
The global bull market continues almost unabated, with a solid earnings season and a "goldilocks" U.S. economy helping to fuel gains. The risk of a pullback has risen, which in our view would be healthy, as it could help prevent a melt-up and keep investor sentiment in check. For now, we believe the trend will continue upward, with some potential bumps along the way.
Important Disclosures
International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
The Chicago Board of Exchange (CBOE) Volatility Index (VIX) is an index which provides a general indication on the expected level of implied volatility in the US market over the next 30 days.
The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
The Intercontinental Exchange (ICE) U.S. Dollar Index is an index of the of the United States dollar relative to a basket of foreign currencies, and is a weighted geometric mean of the dollar's compared to the Euro (EUR), Japanese yen (JPY), Pound sterling (GBP), Canadian dollar (CAD), Swedish krona (SEK) and Swiss franc (CHF) relative to March 1973.
The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.
The Europe Stoxx 600 Index represents large, mid and small capitalization companies across 17 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden.
The MSCI Euro Index captures large cap representation across the 10 Developed Markets (DM) countries in the EMU*. With 123 constituents, the index covers approximately 70% of the free float-adjusted market capitalization of the EMU.
MSCI AC World Index is market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International, and is comprised of stocks from both developed and emerging markets.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
© Charles Schwab
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