Key Points

-Stock prices have been stuck in neutral for the last six weeks, as investors await signs that economic and earnings growth can catch up to recent price gains.
-We think they can, but also believe returns will be modest compared to the last year.

U.S. equities oscillated between minor gains and losses last week before ending slightly down, with the S&P 500 Index dropping 0.2%.1 Investor attention was focused on President Trump’s meeting with Chinese officials, minutes from the last Federal Reserve meeting and rising oil prices. The missile strikes in Syria were also a focus, but had little effect on financial markets.

Weekly Top Themes

1. The labor market continues tightening, which should produce ongoing downward pressure on unemployment. March payrolls expanded by only 98,000, following extremely strong results in January and February.2 For the first three months of the year, however, new jobs have averaged an impressive 178,000 per month.2 At the same time, unemployment has dropped to 4.5%, its lowest level since May 2007.2 From here, we predict monthly payroll growth will average around 150,000.

2. We expect solid first-quarter earnings results. Companies will start reporting earnings this week, and we are forecasting that overall earnings will improve 10% over last year.

3. Corporate tax cuts would be a boon to economic growth. If corporate taxes were reduced from their current 35% rate, we would likely see a boost in investment, better productivity levels, higher GDP growth and stronger income levels.

4. Prospects for corporate tax cuts are being ratcheted down, however. There appears little chance that tax rates could be cut to President Trump’s original target of 15% or even Paul Ryan’s proposal of 20%. We think the best-case scenario may be a reduction to somewhere between 25% and 28%, which would represent only a modest reduction.

5. The Fed minutes indicated the Federal Reserve will likely begin reducing the size of its balance sheet. The central bank may eventually pause rate hikes and instead sell off assets as part of its normalization efforts.

6. The U.S. economy is growing and a recession seems a remote possibility. The Conference Board’s Index of Leading Economic Indicators recently hit a 10-year high in February.3 Historically, since 1975, once that milestone has been achieved, it has taken an average of six years before a recession starts.4

7. Despite stock prices’ recent gains, market uncertainty may be rising. Internal market dynamics shifted during the first quarter, as lower-risk areas such as growth styles, defensive sectors and large cap stocks outperformed the higher-risk value, cyclical and small cap areas. We don’t believe this signals a broader risk-off trend, but it bears watching.

The Reflation Trade Has Paused, but Stocks Still Look Relatively Attractive

Higher-risk areas of financial markets have generally outperformed since early 2016, a trend that accelerated after the election. That rally has stalled in recent weeks. Commodity prices have flattened, bond yields have fallen from their earlier highs and equity prices have traded sideways for the last six weeks. This has caused some investors to wonder if markets are returning to the sluggish conditions that dominated most of the current market cycle, or even if we were nearing the end of the longer-term equity bull market.

We believe neither scenario is the case. Equities appear to have moved into a consolidation phase as investors await more clarity about economic growth trends and corporate earnings. In other words, markets seem to be taking a pause to see if the economy and profits can catch up to the latest valuation expansion. We think the answer is yes, if the economy continues to grow and corporate profits continue to recover. But we acknowledge there is little room for error.

Stock prices have risen sharply over the last year, and we anticipate relatively mediocre return prospects over the next 6 to 12 months. Still, we expect equities to outperform bonds and cash over that time, which argues for maintaining a pro-growth, risk-on stance.

Bob Doll is chief equity strategist at Nuveen Asset Management.

1 Source: Morningstar Direct, as of 4/7/17
2 Source: Bureau of Labor Statistics
3 Source: Conference Board
4 Source: Evercore-ISI