Key Points
• Most data point to better growth conditions in the United States.
• Rising bond yields and higher inflation may act as headwinds for equity valuations.
• We think the economic and earnings backdrop suggests equity prices should move higher.
Investors reacted to a great deal of news last week. Corporate earnings were generally positive, several key economic data sets were released and were better than expected, global sovereign yields rose and Friday saw some unexpected developments in the presidential race. Amid the news, the S&P 500 Index declined 0.7%.1 Of all these developments, we think the yield increase is most significant for equities. The good news is that yields are increasing due to improving nominal growth rather than an inflation scare, but rising yields are likely to pressure stock valuations.
Weekly Top Themes
1. U.S. gross domestic product growth is accelerating, making it likely the Federal Reserve will increase rates in December. Third quarter real GDP grew 2.9%, helped by consumer spending, inventories and trade.2 Importantly, inflation also ticked up, with nominal growth rising 4.4%.2
2. Rising inflation may create economic and market headwinds. Inflation isn’t rising dramatically, but higher levels may act as a drag on consumer spending and overall growth. It could also put upward pressure on bond yields and downward pressure on stock prices.
3. Manufacturing levels are rising. The flash manufacturing Purchasing Managers’ Index rose to 53.2 in October, up from 51.5 in September.3 This beat expectations and indicates that headwinds for growth may be fading.
4. The Conference Board’s Consumer Confidence Index fell in October.4 This comes after two months of improvement, and most other economic indicators are trending positively. If this trend persists, however, weakening sentiment would be a negative development.
5. Improving earnings show the earnings recession may be over. With well over half of S&P 500 companies reporting, earnings are ahead of expectations by 6% and revenues by 1%.5 At this point, it appears year-over-year earnings growth should be about 5%.5
Tailwinds to Growth Are Increasing
For several years, economic growth has been in a Goldilocks phase: Not too hot to trigger significant inflation or rate hikes, but not too cold to raise serious deflation risks. This backdrop has been good for equities and other risk assets. Looking ahead, we expect this environment to persist, and believe that economic growth (and inflation) may accelerate modestly.
One underappreciated economic tailwind may be lower oil prices. When prices collapsed in 2014 and 2015, the negative effects were immediate for the economy and earnings growth. The benefits of lower prices, however, take time to work through the system. The fact that we are seeing manufacturing trends and earnings are improving indicate that these benefits are coming to fruition.
The political backdrop may also turn out to be a positive for growth. Despite Friday’s news about the FBI’s further investigation of Hillary Clinton’s email server and the resulting political turmoil, it looks likely that she will still be elected president. At the same time, it appears very likely that the House of Representatives will remain in Republican hands (control of the Senate looks too close to call). So what will this mean for the economy? As a senator, Clinton had a track record of working with Republicans, and that track record may carry over into her presidency. We also think there will be pressure on the House to create spending legislation that can be enacted into law. These factors could result in some legislative accomplishments early in a Clinton administration. In particular, we think all parties have an appetite for a fiscal stimulus program heavy on infrastructure spending. This could boost economic growth, while also putting upward pressure on interest rates and inflation.
Given our economic views, we think it makes sense for investors to maintain an overweight to equities and other risk assets. Rising bond yields represent a risk, and inflation is creeping higher, but we think improvements in the economy and corporate earnings are solid arguments for equity prices rising over the next year.
1 Source: Morningstar Direct, as of 10/28/16
2 Source: Commerce Department
3 Source: Markit Economics
4 Source: Conference Board
5 Source: RBC Capital Markets