March 2017 Client Newsletter

Since we last distributed a newsletter in early February the market has continued its record run.  We are off to a great start in 2017!  In that newsletter, we discussed the coming transition from a monetary policy focused market, to a market led by fiscal policy.  This month we’ll take a look ‘under the hood’ at a few indicators and ask the question; “Is growth the medicine this market needs to ease the transition?”

First, we will take a look at S&P 500 earnings and we will then focus on broad global growth metrics for the services and manufacturing economy.

Baseline consensus estimates are currently calling for $128 per share in S&P 500 earnings for 2017.  After stagnating for 24 months around $118 per share, this ‘breakout’ in S&P 500 earnings expectations is a welcome development.  The estimate of $128 however, was established prior to the election and does not yet include the new administrations (hopefully) expansionary policies.  An accounting from our research sources on the expected implications of these policies follows. 

As modeled in the chart below, faster GDP growth and higher interest rates could each add $1 to S&P 500 earnings, while a stronger dollar could hurt exporters and lower earnings by $2. Lowering the corporate tax rate by even 1% could add as much as $1.30 to EPS according to some economists, so assuming a 10% reduction in the rate results in a $13 increase in earnings! One more dollar could be added if multinationals are allowed to pay reduced taxes on money currently held overseas, resulting in a one‐time flood of new capital to those companies. The net effect of these potential changes could result in EPS of $142 in 2017, and more than $150 in 2018.

Although the implementation of tax reform, regulatory changes, and a tax holiday on foreign held corporate cash could face some resistance in Washington, their potential significance to the bottom line for businesses has not gone unnoticed.  A chart of 12‐month forward earnings expectations is below; you’ll notice the sustained uptick in expectations since the end of 2016.  Whether these increased expectations actually come to fruition will, of course, require time and monitoring throughout the year.

While the uptick in S&P 500 earnings has helped fuel the new highs in our domestic markets, we have also seen signs of broadening strength in global economic indicators.  This strength, in fact, has accelerated since bottoming in the summer of 2016 and should be supportive to markets.

We have presented the following chart to provide insight into this evolving market story using a gauge of underlying economic activity, the Purchasing Managers Index (PMI).  A showing for a PMI below 50 is a signal of contraction while a showing above 50 is a signal of expansion.  Seen below, the PMIs for Advanced markets (United States, Western Europe, Japan, etc) and Emerging Markets (China, East Asia, South America) are signaling a solid expansion.  Beginning in mid‐2016, these indexes began trending upward.  Currently, the composite Advanced Economies PMI is at 54.6 and the composite Emerging Economies PMI is at 51.9, both new multi‐year highs.

While there is budding strength in the global economy, we do think that significant geopolitical and market risks remain.  As a result, we believe our domestic equity market offers the best risk reward profile.  In the meantime, we will continue to monitor international equity valuations and economic developments for potential opportunities.  

In conclusion, growth is accelerating globally and there is the potential for strong earnings growth for our multinational corporations.  If these positive developments persist, they could provide an ideal environment for global central banks to step back from the massive accommodation they have administered since the global financial crisis.

Alongside the optimistic scenario, it is important to understand that we are still in the early stages of this turn in growth expectations.  These expectations may change as we get more clarity from the administration and central banks and they could cause market volatility.

Absent a significant shift to the outlook for rates and earnings, we believe that the market volatility is worth fighting through in order to achieve the perceived upside.  For that reason, we will continue to study policy developments alongside earnings and economic data on a minute by minute basis.

As always, please do not hesitate to give us a call with any questions about this newsletter or our overall outlook/positioning.