Positive global market trends continued in the 3rd quarter with little disruption. Markets largely brushed off rising tensions with North Korea and several devastating hurricanes. In the U.S., all three major stock indices—the Dow, S&P 500, and NASDAQ—reached new highs during the quarter, suggesting broad-based market strength. Sector data helps confirm this: 10 out of 11 S&P 500 sectors are positive YTD, 7 sectors have posted double-digit gains so far this year, and tech and healthcare—among the largest sectors—are both up over 20%. A rising market with broad-based participation may be more likely to continue its upward trend because it is not dependent on the performance of a select group of stocks.
Underpinning these positive price movements are positive earnings trends. While the earnings growth rate for the 3rd quarter is expected to moderate compared to the double-digit pace seen in the first half of the year, earnings this quarter may still reach record levels as indicated by the chart below (forward estimates in green).
Source: Standard & Poor’s, Springtide Partners, September 2017
The energy sector, benefitting from easy comparisons, is expected to be the largest contributor to the overall growth rate this year and next. However, it is not the only driver of growth. All 11 S&P 500 sectors are expected to have positive earnings growth for 2017 and 2018 (ex-Telecom in 2017), and double-digit growth is forecast in both years for the two largest U.S. sectors, technology and financials. The outlook for revenues also looks solid. Analysts are currently expecting 5% increases for both 2017 and 2018. Strong revenue growth results in higher earnings quality and bodes well for future earnings growth. Finally, we note that current estimates do not include any positive effect from potential corporate tax reform, including a proposed reduction in rates from 35% to 20% and a reduced rate applied to assets repatriated from overseas. While we remain hopeful for bipartisan support of a tax bill in the near term, we acknowledge the current inability of the new Congress to come together on any major legislation.
In addition to positive trends in corporate earnings, stable and improving economic data has supported market prices. Strong new jobs reports, continued positive trends in the composite index of leading economic indicators, and synchronous global GDP growth have all helped equity markets move higher. Notably, for the first time in a decade, all 45 countries tracked by the OECD are expected to grow this year (chart below). This is something that has previously happened only four times in the past 50 years. What’s driving this trend? While the U.S. led the world out of the financial crisis and continues to grow, other regions that felt the pain even more acutely are finally turning the corner, including beleaguered Eurozone economies such as Greece and Italy. The world is also benefiting from stabilization in commodity prices that had severely impacted countries like Brazil, sending it into its deepest recession ever. Finally, consumers and businesses across the globe who had dramatically pared back debt exposure following the financial crisis are starting to return to normal spending patterns. With global inflation still low, this type of synchronized growth could result in a more sustainable uptrend in global GDP over a near-to-medium term time frame. Source: OECD (Organization for Economic Cooperation and Development), Wall Street Journal, August 2017
The actions of the Federal Reserve have also been on investor’s minds. At its recent meeting the Fed left rates unchanged as expected, but left the odds of a December rate hike firmly on the table. They also announced the October start to their balance sheet reduction program. The Fed intends to gradually reduce its current asset holdings of approximately $4.5 trillion to a target level around $2.5 trillion. To do so, they will stop reinvesting principal payments received from maturing Treasury and mortgage-backed securities up to pre-determined cap levels. Cap levels will increase gradually from $10 billion per month to $50 billion per month over the next year and will remain in place until the Fed reaches its target asset level, expected to occur over a multi-year time frame. The Fed has repeatedly downplayed the potential market impact of this plan. After almost a decade of unprecedented monetary support from the Fed, we view this policy normalization as appropriate.
The stock market largely took the Fed news in stride, while the bond market experienced modest declines as yields increased from previous low levels (bond prices move opposite yields). Despite this uptick, the yield on the benchmark 10-year Treasury remains below its high of 2.60% achieved in March, closing the quarter at 2.32%. As we have watched the yield curve flatten this year (typically a bearish economic signal), we welcome the 10-year’s move higher. A steeper yield curve (typically a bullish economic signal) may in fact be a natural side-effect of the Fed’s balance sheet reduction plan, as the majority of Fed assets are intermediate term maturity or greater. Given the historical reliability of the yield curve as a leading economic indicator, this is something we will be watching closely.
The current bull market is now 102 months old, with cumulative price returns of 272% as of quarter end. Historically, it is neither the longest (113 months) nor the biggest (417%), both of which occurred in the 1990s technology boom era. We know at some point the music will stop. However, we view current fundamental trends to largely be supportive of further gains in global stocks, with positive earnings growth being the key going forward. In short, the factors that have historically led to a bear market are not in place: a breakdown in leading economic indicators, extreme valuations, or aggressive central banks. While U.S. stock valuations bear watching, they generally fall within one standard deviation of historical averages across various measures. And if structurally low interest rates are taken into account, they are less expensive than they appear.
* Information provided should not be construed as investment advice and is not meant to be taken as a recommendation to buy or sell. The financial situation and investment objectives of each individual must be considered for suitability prior to any recommendations being made.