Current economic events
U.S. economic data remain solid, reflected in the confidence of the U.S. Federal Reserve (Fed) to raise rates last week. In our view, the economy remains on track for modest growth over the course of 2017, reflecting strong confidence and continued modest gains in spending.
- Confidence indicators remained strong, with consumer sentiment, homebuilder confidence and small business optimism remaining at, or near, post-financial crisis high levels. Some market watchers have expressed concerns that the high confidence has yet to translate into robust activity or spending. Monthly retail sales spending has been somewhat uneven lately and is not directly reflective of the strength we have observed in job growth. Industrial production has also been mixed for the past few months, despite the rise in business sentiment. We believe these discrepancies reflect a couple of issues. First is a shift in consumer appetite from spending on things, to spending on experiences. Second are seasonal factors, especially weather volatility, weighing on this year’s data. In our view, the data are sufficiently strong to support continued economic growth into next year.
One European election is completed, with two more to go in 2017, but political risks may ease in the near term. Dutch election results calmed fears of a populist surge, with the mainstream candidate winning. Risks are likely to continue given the elections still ahead in France and Germany. We favor developed international equities, including Europe, despite the political risks. Earnings growth appears to be improving and stock prices have struggled in recent years.
- Dutch Prime Minister Mark Rutte’s party won the election over populist Geert Wilder’s party, which was in line with recent polling expectations. Two recent major elections, the U.S. presidential election and the U.K. Brexit vote, delivered results at odds with polls heading into the election. Results in the Netherlands seemed to calm markets as we head into the French elections occurring on April 23 (and May 7, if necessary), where populist Marine Le Pen has received significant support. In the meantime, economic data has been positive, with rising inflation, easing unemployment and improving business activity.
Contributed by: Robert L. Haworth, CFA — Senior Investment Strategist
Equities continue to grind higher amidst a Goldilocks-like economic environment.
- Last week, equities trended modestly higher, led by international and small- to mid-sized companies. The international-oriented MSCI EM and MSCI EAFE indices advanced 3.9 percent and 1.9 percent, respectively. The small-cap oriented Russell 2000 advanced 1.9 percent versus the 0.2 percent gain of the S&P 500.
- Year to date, the Russell 2000 Index remains a laggard, up 2.5 percent versus the 5.8 percent to 9.6 percent range of the Dow Jones Industrial Average (DJIA), S&P 500 and NASDAQ Composite indices. Energy and Telecom Services are the two S&P 500 sectors posting losses, down 7.7 percent and 2.4 percent, respectively. The Real Estate Investment Trusts (REITs) sector is up a modest 1.2 percent. Information Technology, Healthcare and Consumer Discretionary are the best performing sectors.
- The Goldilocks-like, not too hot/not too cold, economic environment continues to bolster sentiment and equity prices. Last week, the Federal Open Market Committee (FOMC) noted that “the Committee expects economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.” In addition, retail sales for February increased a modest 0.1 percent month over month, implying that the U.S. economy continues to improve but at a measured, non-inflationary pace, that may bode well for equity performance.
We continue to look for equities to grind higher in 2017 due to modest U.S. economic growth and absent a looming recession or widespread inflation.
- Revenue and earnings are on the cusp of increasing. Manufacturing is rebounding, retail sales are improving, inflation is firming and the global environment appears to be stabilizing, which are all indicators of growth. As of the March 20, consensus is for S&P 500 revenue and earnings to increase in 2017 roughly 6 percent and 11 percent year over year, respectively, with earnings advancing to approximately $130. Ramping earnings, a result of an improving economy, typically imply higher stock prices.
While our outlook remains constructive, the list of warning signals continue to mount, warranting a cautious near-term bias.
- Valuations are elevated. As of March 20, the S&P 500 trades at roughly 21.5 times and 18.5 times trailing 12-month and 2017 consensus operating earnings estimates, respectively, at the high side of the trading range during the 1960s and early-1970s when inflation was near similar levels.
- Complacency is high. The “wall of worry” seems uncharacteristically low, evidenced by the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) being at roughly 11.5, which is toward the low end of its historical range.
- The Fed is raising interest rates. While we anticipate the path toward rate normalization to remain deliberate, bull markets ultimately end when the Fed goes too far in tightening. With indications of inflation beginning to surface, of debate is the extent to which the Fed will let the economy run “hot” before accelerating the pace of future hikes.
- Washington-related uncertainty is high. President Trump’s pro-growth agenda of lower taxes, deregulation, infrastructure spending and reflation has helped shape expectations for future growth while driving equity prices higher. Of near-term focus is the degree to which animal spirits will continue to bridge the gap between policy expectations and implementation. Delayed legislative progress toward this pro-growth agenda would likely be a near-term headwind for higher equity prices.
- The current bull market is of age. Having surpassed the eight-year anniversary on March 9, conceptually, the probabilities of a pullback have risen. However, age alone is no reason to expect a market decline. Rather, markets typically die of fear, often in anticipation of ramping inflation or a looming recession. At present, this does seem to reflect the current environment.
- Technical trendlines appear extended. The popular broad-based indices appear to be ending the first quarter near all-time highs, with the S&P 500 being roughly 8 percent above its 200-day moving average. While equities continue to trend higher, it is unrealistic to expect stocks to advance throughout the year without experiencing a correction.
Our S&P 500 price target for 2017 is 2,475, roughly 4 percent above current levels, based on a multiple of 19 times our 2017 earnings per share (EPS) estimate of $130.
- Upside to both earnings and our price target are contingent on the magnitude and timing of fiscal stimulus. On balance, we favor growth/cyclical sectors over defensives, absent a looming recession or widespread inflation.
Contributed by: Terry D. Sandven — Chief Equity Strategist
Fixed income markets
The 10-year Treasury yield ended last week slightly lower, largely driven by the market response to the March FOMC meeting. The FOMC predictably announced a 25 basis point fed funds rate hike, but the market was surprised to see that the Statement of Economic Projections (SEP) showed little to no change in the Committee’s expectations for growth, inflation or resultant policy actions. Similarly, the statement reference to future “gradual policy adjustments” did not seem to indicate a meaningful change in perception about future monetary policy actions.
The Fed’s latest policy move was seen as a virtual certainty so market participants were particularly attuned to Chair Yellen’s press conference. Yellen addressed many key issues about this policy move and expectations for future moves. She noted the latest move was done in part to avoid “falling behind the curve” as an explanation for the timing. Furthermore, she addressed a question about the timing of the latest move given historically low gross domestic product (GDP) and relatively contained inflation projections by noting, GDP is averaging a rate near the long-term average, job growth has been above the expected sustainable pace and the unemployment rate has continued to drop gradually. Yellen noted domestic fiscal policy uncertainty is still significant and the Committee has not discussed how they would change economic forecasts to consider fiscal policy. Additionally, Yellen addressed a question about balance sheet normalization by noting that the Fed would not plan the timing of ceasing agency and mortgage-backed securities (MBS) reinvestments to a specific date or fed funds target, but would review when qualitative assessments of key economic conditions would warrant such a move.
We recommend reducing allocations on high yield debt to more normal long-term strategic allocations. Yield spreads have narrowed over the last year and are at or below 10-year median levels. Yield spreads are likely fair relative to the current default rate environment, given our expectations for continued modest economic expansion. Nominal yields are still high compared to high quality fixed income and stable economic prospects are still supportive of high yield debt, but they are insufficient to maintain an overweight exposure given the downside risk in a rising rate environment.
Contributed by: Gregory L. Powell, CFA — Senior Fixed Income Analyst
Despite supportive economic data, we remain cautious on the commodity complex. Expectations for inflation and growth within the commodity complex appear to be ahead of fundamentals.
- Speculators have pared their bullish positions in the oil market, but data has yet to turn bullish. Oil rig counts continue to climb, along with U.S. production. The OPEC agreement to cut production appears somewhat fragile, with Saudi Arabia, the primary producer, meeting production targets. Prices are likely to remain under pressure until we get some signal of slowing U.S. investment and production, or a deeper commitment to production cuts by major oil producers.
- Gold saw gains last week, with speculators interpreting the Fed as more cautious on future rate increases. We believe the Fed is still likely to raise rates two more times in 2017, coupled with solid economic growth, which should keep gold under pressure this year.
Contributed by: Robert L. Haworth, CFA — Senior Investment Strategist
If you have questions regarding this information or wish to receive definitions of any terms used, please contact your Wealth Management Advisor.
Investment products and services are:
This information represents the opinion of U.S. Bank. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.
Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded blue chip stocks and is the most widely used indicator of the overall condition of the U.S. stock market. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The NASDAQ Composite Index is a market-capitalization weighted average of roughly 5,000 stocks that are electronically traded in the NASDAQ market. The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) shows the market’s expectation of 30-day volatility and is a widely used measure of market risk and is often referred to as the “investor fear gauge.”
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in mortgage-backed securities include additional risks that investors should be aware of, such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.
© 2017 U.S. Bank (3/17)