At last, both the U.S. and the rest of the world are growing steadily and exceeding expectations. This long-awaited synchronized surge and better-than-expected corporate earnings helped push U.S. stocks to higher-than-average valuations. International stocks followed suit. But can they go higher with the U.S. Federal Reserve raising short-term interest rates? What other risks should investors consider in the second half of 2017?
A Sound Footing for Stocks
Global economic growth boosted stock prices in most major markets last quarter. Equity valuations, especially in the U.S., are now relatively high, supported by a strong earnings season and solid economic data. One growth proxy, the Institute for Supply Management’s Purchasing Managers Index, has attained its highest level in three years. While acknowledging that equity valuations are higher than average, we also observe two animating influences that could provide support to stocks in the near term.
The first influence is corporate earnings. The current level of growth is not strong enough to produce unwelcome levels of inflation, but it has been strong enough to produce an unexpectedly high growth in earnings. Year-over-year earnings growth for the S&P 500 reached 15 percent.
Figure One demonstrates that earnings around the world have risen over the past few quarters. In the U.S., they have surpassed their pre-recession peak, while earnings in other developed markets (benchmarked to the MSCI EAFE Index) are up, but are still well below their peak levels. Europe, in particular, has a lot of ground to make up, and we believe that European companies’ earnings growth could outpace earnings growth in the U.S. over the intermediate term.
Figure One: Reported Earnings (March 2000 – March 2016)
As earnings have increased, so too have stock buybacks, another key influence. Figure Two demonstrates the amount and persistence of this trend. Large U.S. companies in the S&P 500 have increased buybacks from 51 percent of earnings in 2012 to 66 percent (estimated) in 2016—with a peak of 75 percent in 2015. To the extent these companies are underinvesting in their core businesses to increase share buybacks, this trend augurs poorly for future growth, earnings, and productivity. Nonetheless, buybacks reduce the supply of shares available to investors and provide price support for these companies’ stock prices in the short term.
Figure Two: Buybacks as a Percent of Earnings (2012 – 2016)
The positive surprise to earnings can continue for another three quarters or so. This could bolster prices in the short term, but as time passes, earnings comparisons will become more difficult. However, support from corporate share buybacks looks to be sustainable for several years.
Across the Pond
In the U.S., the recovery has proceeded sufficiently for the Federal Reserve to begin raising rates; in Europe, the central bank continues to buy corporate bonds with the aim of decreasing interest rates and credit spreads in order to propel stock prices higher and encourage bank lending. The recent election results in the Netherlands and France have increased confidence in the European Union, benefitting European stock markets.
Additionally, non-U.S. stocks—particularly European and Japanese stocks—are less expensive than U.S. stocks (as measured by their price-to-earnings ratios). We conclude that these lower valuations more than sufficiently discount the well-known risks of lower growth and the possibility of Brexit contagion.
As a result, we remain invested in equities with an overweight to non-U.S. equities. This allocation has benefitted portfolio performance in the last several quarters, and we believe non-U.S. stocks will outperform U.S. stocks over the next several years.
Interest Rate Hikes
Is the global growth we are experiencing strong enough to concern central bankers and cause them to reverse their stimulative monetary policies? Our answer is: no.
Central bankers would like to see inflation rising to 2 percent, along with the prospect that inflation stays near that level. Until they reach that point, we expect most central banks to maintain their stimulative monetary policies of low interest rates and bond buying, which appears to be working. (They must be feeling some relief since they were running out of options.)
In the U.S., inflation is closer to its 2 percent target, the Federal Reserve has increased its federal (or fed) funds rate—the interest rate at which depository institutions lend reserve balances to other depository institutions overnight—from 0.25 percent to 1.25 percent over the past year and a half. We expect two more rate increases of 25 basis points (or 0.25 percent) each later this year—to lift short-term rates to a level at least equal to inflation.
We do not expect short-term interest rates rising to this level to upset the stock market. Interest rate increases typically cause turbulence when they are unexpected or if the fed funds rate is well below the inflation rate. Neither scenario is present today. More importantly, U.S. growth is out of its post-financial-crisis danger zone, unemployment is below 5 percent, and inflation is above 1.5 percent. It is, therefore, an appropriate time for the Federal Reserve to end its program of extraordinary measures.
The Optimism Gap
At present, the U.S. economy is experiencing a noticeable disconnect between business optimism and business owners acting on it. Figure Three clearly shows that optimism (as measured by the NFIB U.S. Small Business Optimism Index) increased steeply post-election. This is a “soft data” point that measures a feeling, not an action. But, while small businesses might be feeling better, they are not acting on it. A “hard data” point, U.S. Small Business Private Employment, shows employment growth at less than 2 percent year over year.
This gap means that either the hard data must get stronger or the soft data will get weaker. An increase in employment would lend support to a continuation of the equity bull market. However, if business optimism falls back toward slower-growth hard data, the stock market will likely decline. The current gap between optimism and employment will likely not be sustainable for more than the next six months.
Figure Three: U.S. Small Business Optimism Index (January 2012 – June 2017)
Issues to Watch
Discord in Washington has created new challenges. Every new administration struggles to find its sea legs as it gets started. The Trump administration is no exception. At inauguration, President Trump—along with Republican House and Senate leaders—gambled that they could achieve two large legislative priorities this year: healthcare and tax reform. This has proved to be overly ambitious so far. However, surveys indicate that investors remain confident that both bills will be passed this year. But if no progress is made, the markets will likely need solid earnings results to maintain their higher-than-average valuations.
In the past, we have highlighted the need for a handoff from monetary policy to fiscal policy—from the Federal Reserve’s easy money policies to Congressional tax and regulatory reform. The economy also needs another handoff—from automobile to new home sales.
Both autos and homes suffered during the recession, but automobile production fully recovered and surpassed the pre-recession peak. Figure Four details new home and auto sales from pre-financial-crisis levels to present. This recovery was stoked by loose credit terms and historically long loan terms. In short, auto production needed lots of subprime borrowers to fully recover. Recently, as borrower delinquencies have increased, banks have tightened their standards. This reduces the number of potential buyers and the sales of automobiles.
Figure Four: New Home Sales vs. Auto Sales (Indexed to 2005 Levels)
New home sales, conversely, are still more than 50 percent below their pre-recession peak. Home mortgage credit has been very tight in response to an extremely tough regulatory environment. In addition, the Consumer Finance Protection Bureau (CFPB) has exacted large penalties from banks and loan servicers who violate consumer rights. JPMorgan Chase Chief Executive Officer Jamie Dimon recently commented that he did not want to make a loan on which the bank might have to foreclose. The best way to accomplish that goal is to make lending standards very strict.
Figure Four clearly shows that easy credit has boosted auto sales and that tight credit has restricted home sales. If housing is going to take the baton from autos in contributing to growth, then we need more relaxed credit terms. Coincidentally, Treasury Secretary Steven Mnuchin and Massachusetts Senator Elizabeth Warren—who established the CFPB while working in the Obama administration—have both spoken of the need for reduction in bank regulations.
Mortgage interest rates are critical for the housing market. Despite the Fed’s short-term rate hikes, home mortgage rates have stayed near 4 percent, which has facilitated the modest rebound in new home sales, and the robust levels of existing home sales. As long as 30-year mortgage rates stay below 5 percent, we believe that the economy can continue to grow moderately.
Tensions on the Korean Peninsula jumped to the top of the list of concerns as North Korea’s demonstration of its intent to test and build nuclear weapons rattled the financial markets. Let’s consider several perspectives on North Korea. To do so, we must examine the potential conflict between North Korea and another country—either the U.S., South Korea, or China—and the post-war plan for North Korea:
- From China’s viewpoint, North Korea provides a welcome buffer between China and the South Korean and American troops at the 38th parallel. If North Korea were to be reunited with South Korea, China would need assurances that Korean troops only would be left in the combined nation.
- If North Korea were to be subsumed by China, South Korea might feel the need to ask for additional U.S. troops on its border.
- Meanwhile, Kim Jong-un is worried that if he relinquishes his nuclear weapons, as Muammar Gaddafi did with his chemical weapons, he will meet Gaddafi’s same fate.
This situation is volatile but not impossible to solve. Geopolitical risks wax and wane and are a normal risk assumed in equity investing.
To summarize, stock values are extended, but earnings growth is improving and stock buybacks provide support—at least in the near term—for higher-than-average valuations. Meanwhile, we do not believe that gradually rising interest rates (and modest inflation) is a risk to the markets. In fact, approaching 2 percent inflation would be a welcome sign of a normalizing global economy. Nonetheless, investors should always be mindful of the possibility of market volatility and expect a market selloff in any given year. Lastly, we continue to search for strategic opportunities to earn non-correlated return.