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Affluent Christian Investor | October 17, 2017

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What Are the Key Themes Driving Equity Markets?

Sao Paulo Stock Exchange.

Key Points

  • Investors have grown more confident about the state of the global economy and the outlook for corporate earnings.
  • We see several risks for financial markets, but believe the equity bull market should persist.
  • Volatility may rise from here, but we think equities should outperform bonds and cash over the next year.

 

Investor Optimism Improves

Following a flight-to-quality trade during the height of hurricane devastation early in the month, investors quickly turned more positive and dove back into a “risk on” approach over the past few weeks. This move was mostly driven by a sense that improving and more synchronized global growth is supporting corporate earnings. At the same time, inflation remains well contained in most major markets outside of the United Kingdom. Investors appear to be betting that improving growth and modest inflation will allow central banks to continue raising interest rates gradually, extending the economic expansion and promoting earnings.

Economic growth does face certain risks. The devastation caused by the string of hurricanes will likely result in a downturn in third quarter growth. Specifically, we have seen some weakness in industrial production, but that has been centered in areas where hurricanes affected the data. Looking ahead, we expect rebuilding efforts will likely lift U.S. growth in 2018. Natural disasters historically tend to have only transitory negative effects on growth, while rebuilding efforts act as a positive, especially when backed by federal spending. In addition to storm damage, tensions between the United States and North Korea have the potential to flare up, but investors seem to be looking past possible economic or financial risks.

Overall, we have a positive view toward the global economy. Most leading indicators are in positive territory, consumer spending is solid and capital expenditures appear to be on the rise. And in the United States, we may see a boost next year in the form of long-awaited tax reform.

Global Politics Become More Equity-Friendly

From a broad geopolitical perspective, the main financial market risk appears to be a possible escalation between the U.S. and North Korea. However, investors appear to be growing desensitized to the ongoing back and forth. A full-scale war between the countries appears unlikely, but a political crisis or even a small-scale skirmish could rattle global markets. The world may have moved past the point of peak tensions. Russia and China (both of which have tacitly or implicitly supported North Korea in the past) have been exerting pressure. China appears to be enforcing trade sanctions, and both countries have agreed to reduce fuel shipments. There are also indications that the U.S. and North Korea have held unofficial diplomatic talks behind the scenes. This implies that North Korea may be under enough pressure to ease off on its aggressive actions and rhetoric. The rise in equity prices and backup in Treasury yields indicate that investors are not focused on the downside risks, but the situation remains fluid.

In the United States, the political backdrop has become more equity bullish and bond bearish. The debt ceiling agreement between President Trump and congressional Democrats delayed a possible standoff until at least December. This doesn’t mean Washington is entering a new era of bipartisanship, but it does ramp up pressure on Republicans to work with the president on tax policy to avoid another deal they dislike. A tax deal is unlikely this year, but we are cautiously optimistic that 2018 is possible. We anticipate a modest tax reform bill reducing corporate tax levels and providing some relief for middle-income Americans. Such measures would likely boost economic growth and be favorable for equities in general and small cap stocks in particular.

 

Inflation Risks Rise

Outside of a possible geopolitical event, the primary issue that investors may want to watch as a possible roadblock for equities and other risk assets would be a surprise increase in inflation. We believe markets are currently priced for little change in the inflation backdrop. We expect inflation to gradually move higher in major developed markets, which should contribute to an increase in government bond yields. Inflation should rise slowly enough not to derail the rally in risk assets. Should inflation climb higher or more quickly than we expect, it could negatively shock bond markets, which could spill over into a drawdown of equity prices.

 

Fed Policy Grows (Slightly) More Hawkish

Prior to the Federal Reserve’s September meeting, markets had not priced in much chance of rate hikes before the end of the year. The tone of the meeting, however, was more bearish than many anticipated as Fed Chair Janet Yellen downplayed low inflation data and the impact of hurricanes on the economy. The Fed clearly left a December rate hike in play. The market-based probability of a December rate hike rose from less than 30% before the meeting to around 70% today.1 Future Fed moves will remain data dependent, and the central bank may need to see at least a small pickup in inflation before it commits to another hike.

The Fed also announced its long-awaited plan to begin shrinking its balance sheet starting in October. The Fed’s balance sheet adjustments will take place on a fixed schedule, implying to the market that they will be predictable and measurable. As such, the balance sheet unwind shouldn’t present risks to financial markets. At the same time, short-term interest rate moves will now be the Fed’s main tool to manage monetary policy going forward.

The Fed’s moves, combined with tapering by the European Central Bank and less asset purchases from the Bank of Japan, are likely to change the supply/demand dynamic for government bond markets. This is likely to put more upward pressure on bond yields (and the dollar), but we don’t expect central bank policy to become aggressive to the point that it will derail equities.

 

Earnings Remain the Critical Driver for Equities

For most of 2017, equities and other risk assets have been pushed higher by a three-legged stool: solid earnings growth, low bond yields and surprisingly depressed market volatility. We think yields are likely to move modestly higher for many of the reasons discussed above. We also expect volatility will rise from extremely low levels, due in part to shifting Fed policy and the possibility of higher inflation. Neither event, however, is likely to have an overly negative effect on equity markets. Yields rose dramatically in September and equity markets took the development in stride. Both the S&P 500 Index and Nikkei 225 Index reached new highs in the month, while European markets advanced as well.1 Likewise, higher volatility may make investing less comfortable for investors, but volatility cuts in both directions.

That leaves earnings as the key factor. And our upbeat assessment of the global economy means we think earnings will continue to improve through the end of 2017 and into next year. The pace of earnings growth may trail off from that point, especially given that year-over-year comparisons could become more difficult. But we expect growth will remain in the mid-single digit range through the end of 2018.

On balance, we continue to advocate an overweight to risk assets, given our expectation for improving global economic growth and corporate earnings. And even if the current pace holds, it would remain an equity-friendly environment. At the same time, we think the long-term trends of a weaker dollar and falling bond yields are coming to an end or have already ended. Financial markets remain subject to downside surprises. Given we expect volatility to rise, this could mean a near-term consolidation or correction in stocks. But we believe equity prices will rise over the next year and outperform bonds and cash.

1 Source: Morningstar Direct and Bloomberg, as of 10/6/17.

 

 

Originally published on Nuveen.

Bob Doll is Chief Equity Strategist and Senior Portfolio Manager at Nuveen Asset Management. Bob appears regularly on CNBC, Bloomberg TV, and Fox Business News discussing the economy and markets.

Bob is also choir director at his local church. He serves on a number of boards, including the Alliance of Confessing Evangelicals, Word of Life Fellowship, New Canaan Society, Kingdom Advisors, the National Christian Foundation, and others.

 

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