Key Points
• Equity prices continue to appreciate as investor confidence is slowly improving.
• In the month since the Brexit vote, contagion appears to be limited.
• The possibility of a spike in bond yields is a key risk, but one we believe is unlikely.
U.S. equities notched a fourth week of gains with the S&P 500 Index climbing 0.6%.1 The primary forces behind the rally remain better-than-expected corporate earnings, stability in the banking sector and a growing sense that equities appear more attractive than bonds given low Treasury yields. In our opinion, the main risk to equities is a possible spike in bond yields. Despite an improving economy and growing prospects for an additional rate hike by the Federal Reserve, however, we think such an event is unlikely.
Weekly Top Themes
1. Investors appear more confident about the global economy. The U.S. housing market and weekly unemployment claims are trending in a positive direction, and the eurozone Purchasing Managers’ Index (PMI) is showing growth.2 Additionally, U.S. equities are at all-time highs, credit spreads have declined and cyclical sectors have been outperforming defensive areas.1 These are all positive signals for global growth. The United Kingdom, however, is a growing source of weakness and is likely headed into recession. The post-Brexit U.K. PMI fell from 52.4 to 47.7, the sharpest one-month drop in history.2
2. Low bond yields and rising earnings are pushing equity prices higher. This is an unusual combination of factors. Despite low Treasury yields, however, we believe deflationary risks are receding.
3. Second quarter earnings have started strong. 30% of the S&P 500 companies have reported results, and earnings are beating expectations by 6% while revenues are ahead by 1.5%.3 Should this pace continue, earnings-per-share would be on track to grow 1.5%.3
4. Prospects for a Fed rate hike may be rising. We think solid U.S. economic growth and so-far limited contagion from the Brexit vote mean increasing odds that the Fed will raise rates in 2016. As of now, investors appear relatively complacent about such prospects.
5. A rising federal budget deficit will complicate fiscal plans for the next president. The deficit troughed last year and is rising faster than expected in 2016.4 This will make it difficult for either Hillary Clinton or Donald Trump to move forward with additional spending programs.
Several Risks Loom on the Horizon
It has now been one month since the Brexit vote, and so far it appears that global economic data has been resilient. The global banking system in particular has remained solid, which is an encouraging sign. It is too early, however, to suggest that Brexit will not have negative economic effects. There is still much to be determined about how the United Kingdom will leave the European Union. The U.K. itself now appears headed for recession, and prospects remain that economic weakness from the country will cause broader contagion. The key measure to watch will be whether global trade levels begin to slow.
The U.S. economy has been able to maintain its pace of mild acceleration in part due to strong jobs growth and still-solid levels of consumer spending. There are risks that could emanate from the United States, however. The political backdrop is highly uncertain, and we think the odds of a Fed rate hike are higher than investors anticipate. Should the Fed act, another 25 basis point increase in the fed funds rate should not have a significant effect on the economy, but it could trigger additional financial market volatility.
Looking ahead to 2017, one of the most serious risks appears to be the possibility of a sharp upward move in Treasury yields. We do not believe such an event is likely. Government bond yields throughout the world remain extremely low and are negative in several countries, which is dragging U.S. rates down. This should keep yields relatively well contained. We anticipate global growth will improve, however, creating the possibility for downward pressure on bond prices that could spill over into other asset classes, including equities. For now, however, investment conditions appear to have improved over the past several weeks and there seem to be more tailwinds than headwinds for stock prices.
1 Source: Morningstar Direct & Bloomberg, as of 7/22/16
2 Source: Markit
3 Source: RBC Capital Markets
4 Source: Congressional Budget Office
Bob Doll is chief equity strategist at Nuveen Asset Management.