HIGHLIGHTS
-Stocks bounced back strongly last week, experiencing their best weekly gains in more than five years.
-Interest rates and inflation are both likely to continue rising, which could contribute to additional market volatility in the months ahead.
-Overall economic and market fundamentals remain stable, which suggests that equity prices can still move higher.
Stocks rebounded last week as investors appeared to return their focus to improving economic growth and solid corporate earnings. The S&P 500 Index jumped 4.4% and experienced its best week in more than five years.1 While stocks remain down for the month, they are back in positive territory for the year.1 Volatility also declined last week as markets calmed down slightly. Treasury yields rose last week as the yield curve flattened. At one point, the 10-year Treasury yield climbed to 2.94% before declining.1 While we may see further market volatility, it appears the worst of the recent correction is in the rearview mirror.
Weekly Top Themes
1. Inflation appears to be moving higher. Investor attention was heavily focused on last week’s consumer price index data. Headline inflation showed a higher-than-expected 0.5% month-over-month increase.2 Core CPI also rose more than anticipated and was up 0.3% for the month and 1.8% year-over-year.2
2. Global bond yields will likely continue to rise unevenly. The recent advance may slow (and perhaps temporarily reverse). We expect the 10-year Treasury yield will cross 3% at some point this year and may even hit 3.25%. Eventually, higher yields may cause a tightening of financial conditions, but we don’t expect negative economic consequences until late 2019 at the earliest.
3. Corporate earnings continue to impress. With 80% of S&P 500 companies reporting, earnings-per-share growth is now over 15%, the strongest level in seven years.1 78% of companies have also posted positive sales surprises, the highest percentage since FactSet began tracking this data 10 years ago.1
4. Companies have many shareholder-friendly options when it comes to tax savings. Based on our conversations with corporate management teams, companies are planning to use their newfound cash in many different ways, including share repurchases, dividend increases, business investment, debt reductions and funding corporate deal activity.
5. Rising capital expenditures could expand an already-long business cycle. Favorable tax treatment of capital expenditures appears to be leading to an increase in this activity.
6. Corporate deregulation has been a driving force behind economic growth. The growth of new regulations has slowed over the past year and others have been delayed, weakened or repealed entirely.
7. U.S. fiscal problems are growing. Deficits are rising quickly and show no signs of stopping. We estimate the deficit could grow to $1 trillion next year. And that could potentially double when the country enters its next recession.
Volatility is likely to remain elevated
The long-term outlook for stocks appears unambiguously positive in our view. Global growth is strong, corporate revenues are rising, profit margins are high and corporate tax cuts are providing additional tailwinds. One caveat to this optimistic outlook is that corporate earnings estimates are becoming more variable and volatile. This variability partially reflects uncertainty over how tax cuts will affect earnings, but it is also due to rising interest rates and inflation, which could eventually become negatives for corporate earnings.