Key Points
- Equity prices are trending down as investors face a host of possible risks.
- In our view, there is a disconnect between financial market prices and economic realities.
- Volatility and downward price pressures may persist, but equities should outperform bonds over the coming year.
U.S. equity prices fell again last week as investors followed the “de-risking” theme that has dominated most of 2016. The S&P 500 Index dropped 3.0% for the week.1 Oil prices staged a slight rebound last week, as expectations rose for coordinated production cuts from OPEC countries and Russia.1 The dollar experienced a sell-off last week as well, which provided some support for the hard-hit commodity-related equity sectors.1 Investor attention remains heavily focused on Federal Reserve policy as market participants scrutinize every economic release and policymaker communication for hints of the timing of the next Fed move.
Weekly Top Themes
1. The January payroll report was mixed, but overall pointed to continued economic growth. The headline numbers showed that a less-than-expected 151,000 jobs were created last month, although the unemployment rate fell to 4.9%.2 The report also showed that wages have been accelerating. Average hourly earnings rose 0.5% in January, putting the year-over-year increase at 2.5%.
2. Corporate profit margins are likely to remain under pressure. Rising wages have the potential to cut into profits. Additionally, productivity measures are weak (productivity fell 3.0% in the fourth quarter).
3. Should these trends persist, it would likely create a negative backdrop for corporate profit margins.
The energy sector continues to weigh on overall corporate earnings. To date, three quarters of S&P 500 companies have reported fourth quarter results. Revenues are in line with expectations, while earnings are ahead of expectations by 4.5%.4 Earnings per share are on pace to fall 2% for the quarter, although excluding energy, EPS would increase by 4%.
4. Corporate buyback levels are high, which could be a potentially bullish signal for equities. Through last week, U.S. companies have announced buyback authorizations of $85 billion in 2016, which is the strongest start to a year in history.
5. The Fed should remain on track to slowly normalize interest rates. Unless market rioting forces the central bank to change its stance, we expect the Fed to stick with its plan to gradually increase rates. At this point, our best estimate is that the next interest rate increase will occur in June.
Stock Prices Should Recover, but it May Take Some Time
So far this year, investors have focused on the negatives and seem to be forecasting a relatively high chance of a U.S. or global recession. Slowing growth in China remains a source of anxiety and could have adverse implications for emerging economies in particular. Wild swings in oil and downward price pressures in commodity markets remain a concern. Investors are also focusing on widening credit spreads, which seem to point to the possibility that tightening credit conditions could put a damper on economic growth. Together, these factors have contributed to a broad risk-off move in financial markets, causing a tough start to the year for equities.
In our view, global economic fundamentals are less dire than market prices imply. It seems to us that investors may be overreacting to fears rather than taking a sober look at fundamentals. We do not believe conditions are in place for a recession in the United States or in the global economy. The U.S. has experienced a moderate economic expansion, and we expect that will continue. Europe should also continue to recover. While Chinese growth is slowing, it remains in positive territory. Falling oil prices remain a risk, but we believe the long-term decline has more to do with oversupply than falling demand.