Key Points

  • The most recent employment and manufacturing reports showed weakness, but we believe overall economic growth should improve in the third quarter.
  • Despite headwinds for corporate earnings and profits, we expect modest, if uneven, improvements.
  • This backdrop should be solid for asset classes such as equities and corporate bonds.

U.S. equities experienced yet another relatively quiet week leading up to the Labor Day holiday. Federal Reserve policy was in focus following the Jackson Hole summit and Friday’s softer-than-expected employment report. Investors also focused on the European Commission’s issuance of a 13 billion euro tax bill for Apple. Oil sold off sharply as the U.S. dollar advanced. For the week, the S&P 500 Index climbed 0.6% as financials outperformed and energy, health care and consumer discretionary lagged.

Weekly Top Themes

The August employment report should keep the Fed on track to raise rates in December. Headline numbers were somewhat disappointing, as a relatively low 151,000 new jobs were created and unemployment remained at 4.9%.2 Hours worked were down and wage growth grew a modest 0.1%. The results are likely weak enough to prompt the Fed to remain on hold at its September meeting.

Despite a slip in manufacturing data, third quarter growth should accelerate. The August Institute for Supply Management Index slipped below 50 for the first time since February. The New Orders Index also fell below 50, a negative sign for capital spending and upcoming corporate earnings results.3 In our view, this decline is inconsistent with other manufacturing reports and could represent a one-month aberration. More broadly, we think positive consumer confidence, spending levels and jobs growth point to stronger third quarter growth.

Corporate profits may continue to struggle, but should show modest improvement. Declining business confidence is putting downward pressure on profits, but low corporate bond yields and improving economic growth should represent tailwinds for profits and earnings. At present, profit levels are running about 9% below their 2014 peak. We expect profits to pick up in the third and fourth quarter, but probably not reach new cyclical highs.
Equity market leadership continues to shift toward economically-sensitive sectors. Markets have traded in an extremely narrow range for the last six weeks, but internal market leadership has shifted toward risk-on and pro-cyclical areas such as financials. In contrast, yield-generating, defensive areas are lagging, with the consumer staples and utilities sectors reaching three-month lows last week.

Growth Trends Point to a Pro-Risk Investment Stance

A key question for investors remains the outlook for government bond yields. Extremely accommodative monetary policies around the world have pushed yields to historic lows. This could cause yields to spike and trigger widespread financial market volatility. But we think the risk of that happening is low. In the United States, Treasury yields will likely remain depressed until the Fed turns decidedly less dovish. While the Fed is likely to raise rates later this year, the central bank has signaled it will remain cautious. The Fed has no desire to move aggressively, given lingering pockets of weakness in the global economy and financial markets, and is concerned about triggering a major increase in the comparative value of the U.S. dollar. As such, we expect Fed policy to become only slightly less accommodative.

We are cautiously optimistic on the prospects for economic and earnings growth, in part due to the low odds of a significant shift in the Fed’s stance. Consumer confidence is improving and spending levels remain high. And with wages finally starting to show growth (albeit at very modest levels), we think prospects for the consumer sector remain bright. This should be a solid driving force for both the economy and earnings. There are potential roadblocks on the horizon, including an uncertain global political backdrop, but we think the prospects for the global economy are at their brightest since the end of the Great Recession.

Global economic growth has been resilient in the face of multiple financial, economic and political bumps, while the profit cycle should turn a corner following six quarters of weak results. The U.S. economy has improved consistently since the early spring, while China and the eurozone have held up reasonably well. We expect to see modestly better results from economic data and corporate earnings reports over the coming quarters. This sort of environment augers well for asset classes such as equities and corporate bonds.

Bob Doll is chief equity strategist at Nuveen Asset Management.