In this quarter’s briefing, we hope to provide clients and friends a well‐rounded view of the current market environment. To do that, we will first recap the areas of strength and weakness in the US equity market. Second, we will discuss the current outlook for earnings and the economy, and to conclude, we will re‐hash a chart from a previous newsletter to take a long‐term view of the interest rate policy outlook from the Federal Reserve.
Rotational = Sensational?
Early this year we headlined a newsletter with the question, ‘Is the market partying like it’s 1999? Or 1997?’ The root of the question was, are we on the cusp of a major market top (1999), or are we in the midst of a late stage bull market poised to ‘melt‐up’ (1997)?
With headlines like the one above gracing the salmon coloured pages of the UK’s Financial Times, it’s hard not to get excited about the prospect of breaking even more new highs. Yet, the impressive string of new highs this year is likely one of the few similarities to the market of the late ‘90s. The market back then was dominated by the ‘.com’ stocks, while the hallmark of the 2017 market has been sector rotation.
Of the 9 sectors in the S&P500, all but 2 (Industrials and Consumer Staples) have been the top performer in at least one month of this year. For example, after Health Care led in February but then faltered in March, Technology picked up the slack. This rotation is how the broad market (S&P, Dow, etc) can continue to post record high after record high.
The continuation of a healthy market will depend on the trajectory of earnings and interest rates, and breadth is the best technical indicator of fundamental health during a market advance. So, as long as this market stays rotational, it could remain sensational.
Earnings & The Economy
US Gross Domestic Product (GDP) was revised up to 3.1% on an annualized basis for the second quarter. While faster GDP growth is ideal, it is unlikely to remain above 3% on a sustained basis. We believe that GDP growth around 2% is more likely to result, as the economy faces secular headwinds such as slower population growth. However, while 2% long term growth for the economy may mean “stall speed” as the below graph illustrates, it is not all negative. This Greater Moderation may result in less variability, which has been a central feature of economic cycles throughout history.
In our March newsletter, we covered the Global Purchasing Managers Index (PMI) to display the anticipated pickup in economic activity around the globe. A PMI reading above 50 is a signal of expansion, while one below 50 is a signal of contraction. The metric has continued to show strength since bottoming in mid‐2016, as the latest survey surged to 54, the highest since 2016.
This data set gives credence to the notion that this global recovery is on solid footing. Further breaking down the regional data, the PMIs for Advanced Markets (United States, Western Europe, Japan, etc.) at 54.6 and Emerging Markets (China, East Asia, South America) at 52.1 continue to exhibit an expansionary position.
Will these positive signals for economic growth result in actual earnings growth? So far, that appears to be the case. Based on current estimates for 2017, the S&P500 is on pace for earnings growth of 10% on the S&P500. For 2018, the consensus earnings estimate of the S&P500 is approximately 11%. If economic growth acts as a catalyst for earnings growth, higher profits could be in store for numerous S&P500 companies. With that in mind, there are many endogenous and exogenous variables to take into account when assessing earnings growth.
The Great Unwinding
In 2008, the Federal Reserve began its first of three unprecedented quantitative easing programs. Along the way, assets on their balance sheet swelled from $900 billion to $4.5 trillion. The Fed is now faced with the task of bringing that number back down to a manageable level without sending financial markets into a tailspin. The process initiated on September 20 allows for $10 billion in assets to “roll off” in the first month, increasing to a maximum of $50 billion per month over the next year. In the words of Philadelphia Fed President Patrick Harker, it should be as slow and boring as “watching paint dry.”
If things go according to plan, interest rates will not feel the effects of balance sheet reduction, and the focus will shift back to the Fed’s preferred policy tool: control of overnight interest rates. The green line in the chart below is the targeted federal funds rate since 1983, with tightening cycles highlighted in blue. In our last newsletter, we noted the difference between the current tightening cycle and previous ones; compared to the Volcker and Greenspan years, the speed and magnitude of rate increases so far has been laughable.
Perhaps the more pertinent discussion is, ‘How much more tightening is in store and where will rates ultimately end up?’ The red line in the chart above represents the Federal Reserve’s median estimate of where overnight rates should be over the long‐term. In 2012, Fed officials expected rates to eventually return to 4.25%. In the latest survey, the median t was a mere 2.75%. For context, the LOWEST rate in the ‘80s and ‘90s was 3.0%, above the newly projected HIGHEST rate. Fed Chair Janet Yellen appears committed to this dovish approach, but her term ends in January. If she isn’t reappointed, her successor will have the opportunity to reshape monetary policy going forward.
Yet again, we find ourselves ending a newsletter with a somewhat rosy outlook on the fundamental prospects for this equity market. So, we must warn, that despite the potential for significantly more upside in this market, there is little doubt in our minds that any number of geopolitical shocks, interest rate shocks, or a stall of the global economic expansion could mark a multi‐year or even generational market top.
As we enter the final months of the year, we are charged with the task of not becoming complacent in the face of a market that continues to drift higher. To stay vigilant, we will continue to monitor the data and underlying pockets of strength/weakness in the market. If necessary, we will not hesitate to protect gains we have achieved so far this year.
If you have any questions about the content in this message, or would like to discuss the markets in greater depth, please do not hesitate to reach out.