I hope you had a wonderful weekend! Today is one of my favorite days. It is “National Get Out of the Doghouse Day”. Have you put someone in the doghouse recently? Are you in the doghouse? Time to get out!
LRPC’s Monday Morning Minute for this week, “2017 Mid-Year U.S. Equity Outlook From Schwab” (presented below) comes to you courtesy of Charles Schwab & Co. As an independent, objective Registered Investment Advisory firm, Lawton Retirement Plan Consultants, LLC has access to research from many sources. Be assured that I will share enlightening, useful information with you each week.
Are you feeling like the U.S. equity markets are a little toppy? Surprisingly, most market experts believe this rally will continue. See what the folks from Schwab think below.
Have a wonderful week!
2017 Mid-Year U.S. Equity Outlook From Schwab
By Liz Ann Sonders, Charles Schwab & Co.
- We may be witnessing an extreme version of “gridlock is good” with record-setting partisan conflict.
- The stall in implementing the Trump administration’s pro-growth policies will likely have more influence on confidence than actual earnings/economic estimates.
- Fed policy likely holds to the key to whether market volatility picks up in the second half.
We say goodbye to the first half of a tumultuous, but rewarding, year and look ahead to the second half to see what might be in store for the U.S. economy and stock market. I travel all over the country speaking with our investors, and a dominant topic — and concern — is about rampant U.S. government and monetary policy uncertainty and why it has not had a deleterious impact on the stock market. Perhaps it just hasn’t had an impact yet. Or perhaps there are forces underpinning this bull market that supersede the political turmoil.
Let’s start with the political environment. No one can deny a level of partisan rancor that exceeds anything witnessed in the past several decades. But is that necessarily the death knell for stocks? Not historically. What the data highlights is the key tenet of the “stocks like to climb a wall of worry” mantra; just in a different form than traditional investor sentiment.
But what about pro-growth policies?
With continued delays by the Trump administration and Congress on its healthcare reform progress, tax reform and other perceived pro-growth policies are getting pushed further out. To date, this has not had a significantly negative impact on stocks; possibly because estimates have not yet been raised for either corporate earnings or overall gross domestic product (GDP) growth.
The hope around policy did have a positive impact on “soft” economic data, which are survey — and confidence-based measures — they surged post-election but have recently been in retreat. I continue to believe the spread between the soft and hard (actual) economic data will narrow with the soft data continuing to catch down to the hard data, until we get more clarity on pro-growth policies’ timing, especially tax reform.
As an aside, I was privileged to sit on President Bush’s bipartisan nine-member tax reform commission in 2005, so got to see the inner workings of trying to push reform through. Let’s just say it’s not easy. I will share that I think tax reform would be great for the economy and markets; tax cuts (without true reform) would be less good, and tax cuts that sunset (i.e., are temporary) would not be good.
The aforementioned soft/hard divide helps to explain the dramatic fall in the U.S. Citigroup Economic Surprise Index, which measures how economic data is coming in relative to expectations. The plunge has been less about U.S. economic data deteriorating, but instead about the expectations bar having been set too high (higher confidence brought higher expectations). I believe the CESI is bottoming as the expectations bar has gotten set lower. A higher trending line is to be expected, at least in the early part of the second half of the year.
What about the yield curve?
Another hot topic is whether the bond and stock markets are sending conflicting economic signals, especially given the flattening of the yield curve. Although the Fed has been raising interest rates — and plans to begin shrinking its balance sheet — longer-term yields have been in retreat and as such, the yield curve has flattened meaningfully.
If the flattening were due to a deteriorating growth outlook it would likely be detrimental to stocks; but most of the fall in longer-term yields appears to be due to lower inflation — a positive for stocks. In the meantime, although yield curve inversions (below the zero line) have been consistently accurate recession indicators, we are still far from that occurring. In fact, the spread is not much below the long-term average. Looking ahead, a risk for the market would be a Fed that is perceived to be tightening policy too aggressively; which could flatten the yield curve further toward inversion; but we think that risk remains low at present.
Also important is that the yield curve has not been a good “predictor” of subsequent one-year equity market returns. On the other hand, the stock market has done a much better job recently. There has been a descending correlation between the yield curve and the following year’s real GDP; and an ascending correlation between the S&P 500 and the following year’s real GDP.
The bottom line is that as we enter the second half, stocks will likely continue to be a better “tell” for the economy than the action in the yield curve — absent an inversion. I believe the stock market is accurate in telling a still-decent story about economic growth and limited recession risk.
What about Fed policy uncertainty
Notwithstanding the aforementioned reasons for lower bond yields and a flatter yield curve, ongoing uncertainty regarding Fed policy could lead to some bouts of market volatility and/or pullbacks. We are in uncharted territory folks, and it could get messy. The Fed is attempting to gently raise rates from the prior zero bound, while soon also shrinking its behemoth $4.5 trillion balance sheet. Success would be if the Fed can gracefully divert the excess liquidity it’s created from financial assets to the real economy.
Since the Fed began raising the fed funds rate in December 2015 — since which time they’ve hiked four times — financial conditions have actually loosened. This is why they are likely to remain on a tightening path, notwithstanding subdued inflation. But it’s also a key reason for the strength in the stock market; which should persist as long as financial conditions don’t tighten too much.
According to the Chicago Fed’s National Financial Conditions Index, which is a weekly view of U.S. financial conditions in money markets, debt and equity markets; along with the traditional and “shadow” banking systems, financial conditions remain in the “looser” zone and have recently been trending even lower. The stock market has experienced its best performance when financial conditions are their loosest.
What about valuations?
My quick down-and-dirty on valuations is that they are elevated; but in the context of low inflation, still-low interest rates, and ample liquidity, the stock market can support them. P/E’s are above-median level. But with inflation remaining in one of the “sweet spots” for valuations, the overvaluation is less extreme. In addition, valuations have actually been coming in a little courtesy of stock market appreciation (the “P”) being lower than earnings growth (the “E”).
So keep an eye on earnings growth as we head toward 2018. The current double-digit pace of growth remains supportive of stocks, but any deterioration in the earnings outlook could be another reason for a market pullback.
U.S. equity outlook summary
Stocks have had a remarkable — and recently drama-free — run over the past eight-plus years. We are likely in a more mature phase, which could be marked by bouts of volatility and/or pullbacks — possible driven by Fed policy. But liquidity remains ample, financial conditions loose and earnings growth healthy; which have underpinned this bull for much of its history. Those are the key things on which to keep an eye as we head into the year’s second half.
Lawton Retirement Plan Consultants, LLC (LRPC) Monday Morning Minute is crafted to provide decision-makers with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
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