Highlights

• A strong corporate earnings season along with solid economic growth should provide support for equity prices.

• Trade tensions intensified as new tariffs were announced, halting recent equity market gains.

• Inflation has been moving higher but is still at low levels.

Major U.S. equity indexes were mixed last week. Geopolitical concerns continued to fuel headlines, with the United States and China both announcing an additional $16 billion of tariffs to be enacted later this month. The U.S. reimposed sanctions on Iran. President Trump announced that metals tariffs on Turkey would be doubled, causing the lira to sell off 20 percent against the U.S. dollar from Thursday into Friday. The S&P 500 Index ended the week down 0.25 percent, breaking a five-week streak of gains.¹ Consumer discretionary led the pack, and consumer staples and REITs lagged.¹

Weekly Top Themes

1. Trade tensions have escalated but also become more concentrated on the United States and China relationship. Other trade disputes have been taking a more constructive direction. In our view, this suggests that the White House is likely to move forward to impose additional tariffs on imports from China, even while the outlook for automobile tariffs and NAFTA renegotiation has improved.

2. Corporate earnings were outstanding in the second quarter. Most companies have reported second quarter results, indicating the fastest EPS growth and the highest percentage of positive EPS surprises in seven years. Sales rose by 12 percent, and margins expanded to a record 11 percent.²

3. Inflation has been trending higher, moving from very low to low. Core inflation, measured by core CPI that excludes food and energy costs, accelerated in July to 2.4 percent year-over-year, which is the fastest growth in a decade.³

4. The political landscape remains in the balance. We believe the Democratic party will be successful in winning the House of Representatives and anticipate the Senate is likely to remain under Republican leadership. We also think the probability that the Democrats could claim both chambers of Congress is higher than the probability that the Republicans will continue to control both the House and Senate.

5. When will be the peak for earnings growth? Many have been apprehensive about equities with such strong earnings reports, and some observers believed first quarter represented a peak in the earnings growth rate. However, peak earnings growth does not generally correlate with peak prices, provided that earnings growth continues to be strong. In January, Thomson Reuters estimated second quarter earnings growth would be 11.4 percent, and this increased to 20.7 percent in July, and the current estimate is now 24 percent. We estimate that the growth in earnings can be evenly attributed to 1) tax cuts, 2) revenue growth and 3) margin improvement/financial engineering.

Equities Have Been Buoyed By Strong Earnings, But Trade Restrictions Are A Wildcard

We are mildly positive toward risk assets, but remain cautious and do not expect a big breakout for equity prices. The U.S. equity market has climbed in recent weeks, fueled by another solid earnings season. As a result, the S&P 500 Index is very close to its late January 2018 high. A decisive breakout to new highs is unlikely until trade disputes ease and global economic growth momentum shows definitive signs of bottoming.

While U.S. equities are near all-time high levels, other markets are struggling or below their best levels for the year. Bond and other commodity markets have sent inconsistent messages. Such divergences reflect confusion on the economic outlook and the significant escalation in global trade tensions. U.S. asset prices have generally ignored these tensions because the U.S. profit cycle has been so strong, and it is believed that the U.S. economy may be better positioned than other economies. Euro area and emerging market equities have been hit hard, but have recently exhibited signs of tentative stability.

Protectionism has the potential to undermine economic activity and become a huge issue for all risk assets, but it is difficult to forecast how it may progress. The U.S. and euro area seem to have mended current challenges, but a trade war remains in focus with China. The NAFTA talks are somewhere between these two extremes.

Looking forward, we remain positive on the global economic expansion, with the key assumption that trade restrictions do not accelerate or deteriorate. We are hopeful that conditions can improve, but the timing may not be until after the U.S. midterm elections.

A window should open for economic sentiment to improve, and bond yields would likely experience a gradual rise in yields. The Federal Reserve (Fed) has not backed away from its steady but slow rate hike schedule. Yet the Fed does not want to restrict monetary conditions, slow the economy or trigger weakness in asset prices. Also, the European Central Bank (ECB) and Bank of Japan (BOJ) remain on the sidelines in terms of raising interest rates. In the near term, U.S. equities will likely stay in current trading ranges.

Robert C. Doll is senior portfolio manager and chief equity strategist at Nuveen Asset Management.

 

1 Source: Morningstar Direct, Bloomberg and FactSet
2 Source: Goldman Sachs and Thomson Reuters
3 Source: Bureau of Labor Statistics