• Third quarter earnings started off poorly, dragging down equity market sentiment.
  • We expect earnings results to improve over the coming quarters, which should act as a tailwind for equities.
  • Investors face a number of risks, but we advocate a cautiously pro-growth investment stance.

U.S. equities retreated last week, with the S&P 500 Index declining 1.0%.1 Sentiment was dragged down by negative earnings updates, a disappointing trade report from China and rising U.S. political turmoil. For the week, defensive and yield-generating sectors outperformed, while materials and health care lagged.1

Weekly Top Themes

Equities may struggle until corporate earnings improve. For the past 18 months, equities have been able to make modest gains despite declining corporate profits. This has largely been due to highly accommodative monetary policy and central banks’ willingness to engage in new easing measures. Additionally, investors have been willing to look past the earnings recession since we have not seen a corresponding economic recession. Looking ahead, we believe earnings must advance for equity markets to make meaningful gains. It is early in the third quarter reporting season, but so far the news hasn’t been favorable.

It may take another quarter before corporate earnings accelerate. At present, consensus expectations are that earnings will decline 3% in the third quarter while revenues rise 3%. Excluding energy, earnings would be up 1% with revenues advancing 4%.2Conditions should improve in the fourth quarter, with consensus expectations pointing to a 6% earnings increase.

The minutes from the September Federal Reserve meeting indicate a December rate increase is likely. The minutes also showed that the decision not to raise rates last month was a close call.

The U.S. economy is unlikely to sink into recession, but remains vulnerable. With nominal gross domestic product growth so low (it has been averaging around 3% this year),3 the economy could falter if we see a sharp oil price increase, a spike in bond yields, escalating political uncertainty or other shocks.

Equity markets may react more positively to divided government. At this juncture, it looks likely that Hillary Clinton will be elected president. The Senate appears up for grabs, which makes the House of Representatives key. We expect the House to remain in GOP hands, but if Democrats take control we would likely see a minimum wage increase, tax increases and further regulations in the health care and financial services industries. Such events would likely trigger additional economic and market uncertainty.
Despite Many Positives, Anxiety Remain High

While investors have focused on an increasingly contentious U.S. political backdrop, the global economy has been reasonably solid. Brexit spillover has not affected the rest of Europe, Chinese growth has remained relatively stable and the United States has been slowly accelerating.

Despite a reasonably decent backdrop, investors have been cautious and unwilling to take on more risk in their portfolios in recent years. This wariness is understandable given the high number of shocks occurring in this cycle, including the sharp collapse in commodity prices, the Greek debt crisis, China devaluing its currency, Brexit, widespread terrorism, geopolitical uncertainty and a fractious U.S. political backdrop.

As a result, stock prices have been trapped in a relatively volatile trading range, moving only slightly higher since the beginning of 2015. Looking ahead, we think the macro backdrop should be conducive for better equity performance. Global growth remains solid and corporate earnings should recover in the coming quarters.

For these trends to translate into firmer equity prices, investors must believe the global economic recovery and earnings cycles will become self-sustaining, meaning that equities will no longer be dependent on monetary policy stimulus. While we remain cognizant of all of these risks, we nevertheless advocate retaining a pro-growth but cautious investment stance.

Bob Doll is chief equity strategist at Nuveen Asset Management.