• Equity markets remain exposed to a number of serious risks, including trade issues, rising bond yields and inflation, stress in the banking system and political turmoil.

• The good news is that corporate earnings continue to improve, which will be critical if stock prices are to rise.

• For now, we think the tailwinds for stocks are stronger than the headwinds, but we will need to see risks diminish before equities can break out of their trading ranges.

Investors continued to focus on a wide range of big-picture risks last week, including economic growth data, inflation, U.S. political turmoil, geopolitical issues and trade worries. The good news was that investors could also react to first quarter earnings results, which have started off quite strong. Markets rose early in the week before sinking on Thursday and Friday, as the S&P 500 Index climbed 0.5 percent.1 The energy and industrials sectors were the best-performing areas, while consumer staples and technology lagged.1 Treasuries also came under pressure as yields rose to their highest levels in years.1

Weekly Top Themes

1) Trade risks have faded recently, but remain a threat. Investors appear more sanguine about several trade-related risks, including prospects for NAFTA and tariffs on steel and aluminum. Relations between the United States and China, however, remain a source of concern. We expect Washington and Beijing will eventually reach some sort of detente that avoids an escalating war of more tariffs and other punitive actions, but the outlook remains uncertain.

2) First quarter corporate earnings have been highly impressive. With approximately 20 percent of companies reporting, 81 percent have exceeded expectations by an average of 6.4 percent.2 This compares to an average beat of 4.7 percent over the last three years, which underlies the strength of this quarter.2 Much of the strength has come from reduced tax burdens: Earnings-per-share is on track to grow 23 percent, but would only be 16 percent were it not for the effects of lower taxes.2

3) Rising inflation represents a risk for financial markets. U.S. inflation data has been creeping higher, and we believe inflation will reach the Federal Reserve’s stated target of 2 percent before the end of this year. While the increase should be gradual, higher inflation will likely contribute to equity market volatility and downward price pressure on bond markets.

4) Higher bond yields are becoming a reality. Equity markets have staged an impressive rally in recent weeks, climbing close to 5 percent, but appear to be losing steam.1 We think some of this weakness is due to higher bond yields: The 10-year Treasury yield ended last week at 2.96 percent, its highest level since early 2014, while the 2-year yield reached 2.46 percent, its highest level since 2008.1 As with inflation, higher yields will complicate the investing landscape.

5) Future equity price gains are likely to depend on rising corporate earnings. For the past six years, corporate earnings have improved while price/earnings levels have moved higher. This year, we expect earnings will continue to rise, but valuations should drop, or at best remain flat. This means that rising profits and earnings will be needed for stock prices to move higher.

Downside Risks Appear More Prominent For Bonds Than For Stocks

Equity markets have been buffeted by a number of credible threats so far in 2018. The dollar has lost value, trade tensions have escalated, global government bond yields have spiked, and the LIBOR-OIS spread (the difference between the interbank lending rate and overnight indexed swap rate) has widened, which is a sign of stress in the banking system.

Global growth momentum is likely to downshift this year at the same time that inflation creeps higher and monetary conditions slowly become less accommodative. This looks to be a negative environment for many areas of the bond market, especially for government sectors. In contrast to movements in financial markets over the past several years, we expect bond yields will rise more meaningfully during risk-on phases. This will put increased downward price pressures on fixed income assets.

We believe these and other risks will continue to trip up equities, but shouldn’t be enough to actually cause a bear market. At the same time, we think these risks will need to ease before stocks can regain their footing. So far, trends have been mixed: The dollar has consolidated losses since January and the LIBOR-OIS spread widening has paused, but trade risks remain and bond yields have started rising again.

The correction and consolidation in equity markets that began in early February has taken some froth out of the markets, and stock prices seem to have settled into a broad trading range. Equity volatility has remained elevated and that isn’t likely to change, but the good news is that corporate earnings continue to improve.

For now, it appears that the tailwinds for stocks remain stronger than the headwinds, but given all of the possible downside risks, we do not expect equity prices to chart new highs any time soon. As such, this remains an environment in which investors will need to be tactical and more selective in their portfolios in order to find investment opportunities.

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

1 Source: Morningstar Direct, Bloomberg and FactSet. 
2 Source: Credit Suisse