Key Points
• U.S. economic data suggest an eventual improvement in corporate earnings results.
• Several risks that were causing investor consternation have faded.
• Nevertheless, while we have a positive long-term view, we remain cautious about the near-term prospects for equities.
U.S. equities snapped their five-week winning streak and dropped slightly in a holiday-shortened trading week as the S&P 500 Index fell 0.7%.1 The news was dominated by the terrorist attacks in Brussels, but outside of a short-lived move to safe-haven assets, the horrific events appear to have had limited market impact. Instead, investors appeared to have taken a step back in response to some more hawkish comments from Federal Reserve officials and a sense that the strong rally since mid-February may have been overdone.
The U.S. Economic Backdrop is Solidifying
While markets have rallied strongly over the past couple of months, it should come as no surprise that investor skepticism remains high given that we have seen numerous ups and downs in the market over the past several years. That said, however, it does appear to us that the economic backdrop is providing more indicators that the bullish argument may eventually bear fruit. The ISM Manufacturing Index has climbed for two months in a row, and we expect March’s numbers may improve as well.2 Additionally, both the Empire and Philadelphia Fed manufacturing surveys have been showing strength.3 The recent rally in commodity prices and the decline in the value of the dollar are also positives for equities.
The U.S. economy may be finally benefitting from the numerous sources of stimulus that materialized last year. Lower interest rates, rising monetary supplies and the long-term fall in oil all come with positive long-term effects, which may now be providing support. The ongoing strength in the labor market, improving consumer spending and what appears to be a long-awaited turnaround in manufacturing suggests that the U.S. economy remains in a slow-but-steady state of improvement.
Downside Risks Remain, but Appear to Be Easing
There are, as always, risks investors must consider, but from a broad perspective, risk factors seem less pressing than they did several months ago. The Fed’s recent indication that it will slow its pace of rate increases provides more certainty for financial markets. Inflation appears to be rising, but remains below the Fed’s 2% target level, which gives the central bank added flexibility.4 At some point, rising prices and wages will constrain the Fed, but for now it can continue to move slowly. On a related point, the softer dollar has removed some risk from the economy and financial markets as this has helped to stabilize commodity prices and emerging market currencies. The weaker dollar should also provide some sorely-needed support for corporate earnings.
Geopolitical flare-ups and terrorism have unfortunately become a fact of life and continue to have the potential to disrupt economic growth and financial markets. But while the human costs of such events can be heartbreaking, their effects on investors have tended to be contained.
Improvements May Be Necessary for a Sustained Advance