• Economic data have improved over the past couple of months, and the U.S. remains better positioned than the rest of the world.
• Investor sentiment remains weak, and it will take additional clarity for it to recover.
• We think the long-term outlook for equities is positive, but only if corporate earnings results improve.
Equity markets retreated last week amid multiple crosscurrents as the S&P 500 Index fell 1.2%.1 Currency and commodity markets were in focus. The soaring value of the yen complicated the Bank of Japan’s interest rate decisions, while oil prices rose sharply on expectations for improved global economic growth and a possibility of production cuts. Investors also focused on the regulatory environment, as the Treasury Department rolled out restrictive rules governing corporate inversions.
Weekly Top Themes
1. The corporate earnings backdrop remains challenged. S&P 500 earnings growth has contracted for two consecutive quarters, and we expect another contraction when first quarter numbers are final.2 Analyst expectations are for additional weakness in the second quarter, which would make four consecutive quarters of declines.2 To date, most negative results have been centered in energy and related industries, but the weakness appears to be spreading. We may see negative year-over-year results in the first quarter across a wider range of industries.2 We expect the earnings picture to improve in the second half of the year. Without such changes, it is difficult to make a constructive case for equities.
2. The U.S. economy remains reasonably healthy, especially compared to the rest of the world. Jobs growth in particular has been a source of strength. Payroll employment is more than 5 million above the 2008 peak, and the unemployment rate has fallen from over 10% in 2009 to 5% today.3 Even the labor participation rate is picking up, growing 3.9 million over the last two years, the fastest rate since 2007.3 Manufacturing is starting to pick up as well, and the sector appears to be overcoming foreign weakness and the secular decline in oil prices. On the negative side, modest debt growth and rising savings levels are acting as a drag on consumer spending. Overseas weakness is also causing problems for U.S. export-related industries. And, finally, the U.S. economy still grapples with volatile energy prices.
3. Market conditions have improved in recent weeks, but more clarity is needed. The market backdrop is clearly better today than it was in mid-February. Global economic growth appears more stable, credit spreads have narrowed and risk asset prices have recovered. We do, however, believe we will need to see evidence of additional fundamental improvements before equities can experience a sustained uptrend. In particular, we await improvements in corporate revenues and earnings. We also think we need to see additional oil price stability and evidence that consumer spending will remain stable. In our view, the biggest negative risk is the possibility of a renewed deflation scare or some sort of negative credit-related event. If credit issues were to arise, we think they would most likely be focused in commodity-related industries and markets.
Investor Confidence Should Improve Over Time
The economic picture has improved over the past couple of months. Early in the year, many feared that weakness in U.S. and Chinese manufacturing would trigger a recession, but those fears have faded as those data sets have strengthened. Despite these improvements, confidence remains fragile, investors are calling the strength of the global economic recovery into question and many remain wary about the prospects for rising rates. As a result, risk aversion remains high, which explains why government bond yields remain so low.
We understand the lingering pessimism, but disagree with the factors that underlie it. We believe the U.S. economy will remain in a slow expansion mode and expect an increase in consumer spending. We also believe that corporate earnings are likely to improve in the second half of 2016, providing an important tailwind for equities.
In the near-term, we acknowledge it may be difficult to determine when investor sentiment will recover and expect it might only do so after a more extended period of better economic results. Periodic market setbacks are likely inevitable until more market clarity emerges. Nevertheless, we think it makes sense to retain a pro-growth investment stance, believing that risk assets should advance over a six- and twelve-month basis. We have a favorable view toward equities, but this is predicated on our belief (and hope) that corporate earnings will recover later this year.
1 Source: Morningstar Direct, as of 4/8/16
2 Source: J.P. Morgan
3 Source: Cornerstone Macro & The Department of Labor
Bob Doll is chief equity strategist at Nuveen Asset Management.