Key Points

• Equities rallied again last week and are near the top of their current trading range.
• Earnings and global economic growth are mixed, but should improve as 2016 progresses.
• Should this growth occur, we expect equities will break out to the upside, with leadership shifting toward non-U.S. stocks.

Equities climbed yet again last week, with the S&P 500 Index rising 0.5%.1 Corporate earnings were mixed, and the biggest market story was ongoing strength in commodities, particularly oil and metals. Bank stocks rallied strongly for a second week, while defensive market segments struggled to keep pace.1

Weekly Top Themes

1. Energy continues to weigh on corporate earnings. With one-quarter of S&P 500 companies reporting, earnings are beating expectations by 3.5% and revenues are showing upside surprises of 0.5%.2 Overall earnings-per-share growth projects to be down 5.0% for the quarter, but ex-energy would be up 1.0%.2
2. The first quarter looks to be the fifteenth in a row where U.S. domestically-oriented corporate earnings lead the way. This market segment should experience earnings declines of around 3%, while internationally-focused U.S. company earnings are on track to decline 14%.2
3. Economic growth should accelerate after a weak first quarter. First quarter gross domestic product growth data will be released on Thursday. We expect it will show the economy grew by 1% at best. Growth should bounce back in the second quarter, led by improvements in consumer spending and manufacturing.
4. The Federal Reserve will likely increase rates two times in 2016. For the past several years, the Fed has successfully stimulated economic growth and helped stave off deflationary pressures. At this point, we believe the economy is accelerating and inflation is slowly rising. As a result, we think the Fed will likely continue a slow and gradual pace of rate increases.
5. The current trend of U.S. dollar weakness should fade. The recent drop in the value of the dollar is due to dovish comments by Fed officials and strengthening commodity-oriented emerging market currencies. Both factors should diminish as we approach the next Fed rate increase and as commodity prices stabilize into a less volatile trading range.

Equities Should Outperform Over the Long Term

Equities and other risk assets (most notably high yield bonds) have rallied nicely over the past couple of months.1 In hindsight, it seems investors were overly pessimistic about the possibility of a recession and overstated the risks of plunging oil prices earlier this year. Economic data is choppy, but we believe the U.S. economy is clearly accelerating. And it also appears evident that the decline in oil prices was due more to a supply glut than falling demand.

The current rally appears to be powered by two primary factors: stabilizing Chinese growth and a more dovish turn by the Fed. Clarity from China has boosted oil prices and eased concerns about currency devaluation. And a less hawkish Fed decreased the value of the dollar and kept bond yields low, even as stock prices rallied. The longevity of both of these factors needs to be questioned, however. The Chinese economy is still slowing and could continue to act as a deflationary force on the global economy. And we think the Fed is still in a rate-hiking mode. This could potentially disrupt the equity rally, especially as we approach the next increase, which we think will happen this summer.

So where does that leave equities? Stock prices are near the top of their recent trading range, and we think corporate earnings improvements and stronger global economic growth are necessary for equities to break out to the upside. We expect both catalysts will materialize, but probably not until later this year. At the same time, stronger economic growth and rising inflation will put upward pressure on government bond yields. We believe there is a disconnect between current low yields and the reality of the economic and inflation picture. This makes Treasuries and other government bonds vulnerable.

As a result, we think equities are poised to outperform bonds over the coming year. So far in 2016, U.S. equities have outperformed most other markets. We anticipate market leadership should rotate away from U.S. stocks sometime this year, but probably not until confidence in the global economy rises.

1 Source: Morningstar Direct, as of 4/22/16 
2 Source: RBC Capital Markets