Key Points

• U.S. economic growth was weak during the first quarter, but should accelerate from here.
• We expect the Fed to enact another rate increase at some point this summer.
• Equity markets may be volatile over the coming months, but should rise once corporate earnings improve.

Equity markets fell last week, with the S&P 500 Index declining 1.2%.1 Monetary policy was in focus. The Federal Reserve meeting generated debate about the timing of the next rate hike and the Bank of Japan surprisingly failed to move rates even further into negative territory. Earnings were generally weak, while a fall in the value of the dollar led to another rally in commodity prices.1

Weekly Top Themes

1. First quarter economic growth was sluggish, but the economy should gain steam in the coming quarters. U.S. real gross domestic product advanced only 0.5% last quarter as the consumer sector remained steady, housing activity improved and capital expenditures were weak.2 Looking ahead, we expect both consumer spending and capex to improve, which should help the economy advance at a more moderate pace.

2. We expect the next Fed rate increase this summer. In its statement last week, the Fed indicated it is less concerned about global financial risks than it previously was, and also pointed to continued mixed economic performance. We think the central bank is focused on ongoing improvements in the labor market and is prepping investors for a probable rate hike in the coming months, provided economic data improve.

3. Earnings are likely to fall again for the first quarter. With 60% of S&P 500 companies reporting, earnings are slightly ahead of expectations (up 4%) while revenues are flat versus forecasts.3 Overall, earnings growth is set to decline by 4%, but would be up 1% ex-energy.3

4. Near-term dollar weakness may persist, but the dollar should strengthen later in the year. Despite recent weakness, investors still appear bullish on the dollar. Improving economic growth and the likelihood of higher interest rates should apply upward pressure.

5. Investors are viewing higher oil prices as a positive. The S&P 500 Index has risen close to 15% over the past couple of months and is now only a few percentage points away from its all-time high.1 The price increase has caused valuations to expand, which in our experience does not typically occur when commodity prices rise. This suggests that investors believe rising oil prices are removing some risk from the global financial system. In essence, investors are willing to accept higher energy costs for U.S. consumers if it means countries such as Russia face less economic pressures.

Equity Markets Appear Tired, but We Expect Improvements in the Coming Months

Risk assets have traded unevenly over the past couple of weeks as investors have reacted to a variety of crosscurrents, including relatively weak earnings, rising oil prices and mixed economic news. Investors are left to decide whether to double down on government bonds and other safe-haven assets, or trust that conditions are improving, and turn toward equities. Over the long-term, we think the latter course makes sense. Economic growth is improving. Earnings should accelerate. And inflation remains low. These are all long-term positives for stocks.

Monetary conditions are, admittedly, a wild card. At present, global monetary policy remains accommodative. The Fed is due to raise rates at some point, but even another rate hike (or two) would leave rates quite low relative to the condition of the economy. Additionally, corporate earnings are not currently strong enough to increase equity prices. Earnings forecasts are finally starting to turn positive, however, which is a strong sign considering economic growth has been so uneven.3

At this point, economic growth is not quite sufficient to entice investors to move out of safe-haven assets and take on more risk. And many are appropriately wary of the strong rally that has occurred over the past couple of months. Equities, high yield bonds and commodities may be overbought, and it would not be a surprise to see some sort of consolidation or pullback.

Over time, we expect a gradual improvement in global economic growth and a rebound in corporate earnings. These developments should be enough to allow for a climb in equity prices. As such, we expect equities to outperform bonds and cash over a six- to twelve-month time horizon.

1 Source: Morningstar Direct, as of 4/29/16
2 Source: Bureau of Economic Analysis
3 Source: RBC Capital Markets