Corporate earnings growth, an expanding economy and ample liquidity remain supportive of the current bull market. Earnings and economic growth, more than potential fiscal and tax policy, have been the catalysts for higher stock prices.
Despite already strong performance year-to-date, we believe equities will continue to post solid returns through the rest of 2017. Our conviction rests on the premise that stock performance is largely driven by the strength of corporate earnings, the economic cycle and liquidity. A breakdown or dysfunction in one area of the chain renders the entire operation useless. There is a symbiotic relationship between these variables. Each one is very important for the overall equity ecosystem. Each of these factors should remain supportive, at least for the next few quarters.
First, we acknowledge investor concern regarding the potential vulnerability of late-cycle equity performance. The current cycle is already eight years long, the Fed is in tightening mode, and the unemployment rate is very low - arguably poised to push up labor costs and eat into corporate margins. Yet, as in previous cycles, bulls contend “this time is different,” and there is some condition in the economy or market that will allow valuations to continuously defy gravity. Optimism is quite evident in all of the sentiment surveys, which is normally a good time to start looking for the exits. This is sage advice in most markets but it’s important to remember this hasn't been a typical market cycle. Here’s why we remain with the bulls, for now.
The case for optimism
U.S. economic fundamentals remain solid, with low unemployment, benign inflation, expanding manufacturing activity and buoyant consumer and business sentiment. Although the economy grew at a weak 1.2% rate in the first quarter, we believe GDP growth in the second quarter will pick up, as there is persistent seasonality associated with the first quarter. One of the best ways to get an early gauge of economic activity is the Atlanta Fed’s GDPNow assessment, which currently forecasts 2.9% GDP growth for the second quarter. Importantly, the global economy also continues to show signs of life. As global economies and supply chains become ever more connected, international growth should help buoy U.S. expansion prospects.
The second component that drives market activity is earnings. There are usually two times as many earnings recessions than economic recessions. The difference between the two is that earnings recessions are usually shallower and shorter than their economic counterparts. Whenever you buy a stock, you essentially buy that company’s future earnings potential. Higher earnings generally equates to higher stock prices and vice versa. Numerous studies show that stock market valuation over the very long term is a function of earnings growth. Of course, the economy and liquidity help determine earnings, hence the delicate ecosystem, but the markets have moved higher over the past 16 months not because of pro-growth fiscal enthusiasm but rather earnings. If the Trump trade was driving this positive momentum, would the market have remained so resilient in the face of recent political volatility?
The S&P 500 Index has run up approximately 13% since the election. But recall that even before the election, equities recovered notably in the first half of 2016 after the energy-induced profit recession failed to spill over into the broader economy and China’s stimulus measures helped extend the global economic cycle. The latest earnings recession from 2014 to early 2016 has petered out, without inducing a broad-based recession across the U.S. economy. This, undoubtedly, is a tailwind for the stock market. Indeed, the markets have moved up approximately 32% since the intra-cycle low reached on Feb. 11, 2016. The current rally started well before the election on the anticipation of stronger earnings and better global growth.
We can get a sense of the market impact of the new administration’s agenda by comparing the relative performance of companies most affected by it. The potential benefits of tax reform are a good proxy. Many sell-side firms have come out with a basket of companies with high effective tax rates compared to companies with low effective tax rates. The markets have witnessed a complete unwind of the high tax portfolios’ relative outperformance. What are the implications? Even if Trump fails to make any progress in his agenda, the markets are not set up for a negative surprise because expectations are already extremely low. Post-election, investors had unrealistically high expectations for meaningful tax, regulatory and spending proposals. Today, market participants have unrealistically low expectations for what this administration can accomplish. If the market is going to move on Trump-related developments, it is more likely to be to the upside rather than a sell-off.
We believe this creates a non-trivial upside probability, because there is a better chance than not for a large tax cut with some reform elements. If Republicans are unable to move forward on any agenda items with a majority in Congress and a friendly White House, the midterm elections could prove disastrous. Self-preservation is a strong motivator, and the pressure to pass tax measures should overcome the differing views on debt within the party. The tax cut will likely be less than initially thought but we expect it to make a small positive impact on 2018 earnings and economic growth. Whatever materializes - whether it is forced repatriation or a one-time tax holiday - should provide a nice tailwind for traditional shareholder friendly activities, such as buybacks, dividends, and M&A activity. Corporations have been the biggest buyer of stocks during this recovery, according to FactSet. Right now, there is about $2.5 trillion of capital locked up abroad. If half of it comes back home like it did in 2005, corporations will have over $1 trillion which could find its way into the market through buybacks, another plus for equities.
Despite more subdued earnings expectations for the second quarter compared to stellar first-quarter results, economic indicators continue to provide tailwinds to corporate margins. One economic indicator that correlates fairly strongly with S&P earnings is the Institute for Supply Management’s Purchasing Managers Index (M-PMI). This is somewhat surprising given that manufacturing makes up only 11.6% of the U.S. economy. But the change in the S&P 500’s earnings per share over the previous four quarters tracks M-PMI pretty closely, albeit with a two-quarter lag. This measure was extremely helpful in calling the bottom of the earnings recession of 2015. Using this measure, M-PMI bottomed in December of 2015 and sure enough, we were out of the earnings recession six months later. Right now, M-PMI is at a healthy 54.9% (anything over 50% is expansionary), signifying that earnings should continue to gather steam over the next few quarters. The combination of M-PMI strength, continued corporate buybacks and a rebound in consumer spending should keep corporate earnings on solid ground.
Plenty of liquidity
The last key variable for the health of stocks is liquidity, which greatly impacts the economy and the business cycle. The institutions that create the backdrop for liquidity are central banks and, specifically, the Federal Reserve in the United States. The Fed has had 16 interest rate hike cycles in its history with 13 resulting in recessions. U.S. dollar strength also impacts financial conditions. With $10 trillion in U.S. dollar-denominated debt outstanding globally, a strengthening dollar reduces global liquidity as debt burdens become harder to service. Therefore, it is important to watch and anticipate the Fed’s likely policy movements and dollar (USD) strength, as well as their respective implications for financial conditions.
Financial conditions are very loose given where we are in the cycle. Despite the Fed’s admittedly gradual tightening, the USD has weakened so far in 2017. We anticipated this coming into the year because of the history of Fed interest rate cycles. The dollar has weakened in six of the last seven rate hike cycles, losing 18% on average after the first rate hike of the last three cycles. There are undoubtedly other factors at play: not least, expectations for the path of tightening relative to real economic growth. From this perspective, the market may be pricing in further economic expansion, even given the tightening path that the Fed has announced. Although the Fed has now hiked four times, this is still an extremely accommodative stance considering the maturity of this market cycle and an unemployment rate at a 16-year low of 4.3%. Furthermore, longer-dated rates remain very low by historical standards and have declined further this year. This is stimulative not only to consumers and the housing market, but also to businesses looking to access the capital markets.
Helped by low Treasury rates, investment grade and high yield spreads also remain very narrow by historical standards. Spreads gauge the price of debt financing for corporations, and, by this measure, financing remains ample, buoying financial conditions and the economy. Typically, signs of stress in the financial markets will manifest first in the bond market before spreading more broadly to other asset classes. Spreads have moved considerably lower over the past 12 months and are near a cycle low over Treasuries.
Taken in aggregate, liquidity is abundant and financial conditions are still very loose. The Fed is moving forward with normalizing policy but its pace of tightening should not be a major concern to the markets over the next 12 months.
Some investors may be nervous given how long this market cycle has lasted. Fear is more prevalent today because we haven’t had a pronounced sell-off of 15% or more in quite some time. The S&P 500 hasn’t seen a 15% correction in over 1,400 days - the third longest stretch of positive momentum behind the periods in the 1990s and 1950s.
Such a lengthy period without a correction is unusual and some investors could extrapolate that a prolonged sell-off is coming. Bad streaks always follow good ones, but the good streaks can last a long time. The two streaks that have lasted longer than our current one each logged about 2000 days - a full two years longer. The point is, bull markets don't die of old age. And although a market pullback is quite possible over the next several quarters, we would view these pullbacks as buying opportunities. The three pillars of a higher market remain intact: the economy continues to slowly move forward, earnings continue to surprise to the upside and liquidity remains abundant.