Highlights

• Equity prices jumped last week as investors viewed shifting geopolitical developments as good news.

• Rising inflation represents a possible risk to economic growth, but we expect inflation to advance only gradually.

• Corporate earnings should continue to improve, helping equity markets.

Investors reacted to a number of political and economic developments last week, and, in general, most chose to focus on the positives. Oil prices rose to a three-and-a-half-year high when President Trump announced the withdrawal from the Iranian nuclear accord.¹ Rising oil prices helped fuel a risk-on rally, as cyclical sectors outperformed.¹ The S&P 500 Index jumped 2.5 percent for the week with energy, financials, technology and industrials all climbing more than 3 percent.¹ Defensive and income-oriented areas of the market lagged.¹

Weekly Top Themes

1. We expect inflation will continue to rise, but only gradually. The April’s Consumer Price Index rose slightly to 2.5 percent year-over-year, while core inflation held steady at 2.1 percent.² Looking ahead, we think higher levels of capital expenditure spending and improving productivity should help prevent inflation from rising faster than it would otherwise. We expect headline inflation to be between 2.5 percent and 3 percent by the end of the year, with core inflation trending around 2.5 percent. These levels should allow the current economic expansion to continue.

2. Easing trade tensions are acting as an equity market tailwind. The mere fact that trade issues have not escalated is being viewed as a positive by investors. The U.S. and China are continuing to hold negotiations, and Chinese officials are scheduled to be in Washington this week for additional talks. Preliminary indications are that China may agree to import more U.S. goods, which would be a plus for the U.S. economy.

3. Equity market reactions to the U.S. withdrawal from the Iranian nuclear accord have been muted so far. President Trump’s decision was more hawkish than expected, as the president did not offer to continue negotiations with other signatories.

4. The president’s remarks on drug pricing are likely to be a short-term positive for the health-care sector. Additional details are needed, but the president seems to be advocating more for incremental changes rather than disruptive fundamental reforms.

5. Republican’s prospects for the midterm elections appear to have improved this week. The GOP nominated mainstream and competitive candidates for several key races in the fall, most notably in the West Virginia and Indiana Senate races that feature vulnerable Democratic incumbents. We think it is likely that Democrats will capture the House of Representatives this fall, but think the Senate should remain in Republican hands.

The Current Economic Expansion Should Continue, Helping Corporate Earnings And Equity Prices

Softness in first quarter economic data has led to fears that the economic expansion may be coming to an end, but we think such concerns are premature. We see few signs that suggest an end to the current cycle, either in the United States or around the world. Indications of an escalating trade war have eased, although it is certainly possible that trade rhetoric could again heat up before more agreements between the U.S. and China are reached.

The tightening labor market and rising inflation levels are likely to put additional pressure on the Federal Reserve to continue increasing interest rates. But the Fed has been clear that it will raise rates gradually, and current policy does not appear close to the level that would jeopardize the economic expansion.

Given this backdrop, we expect the environment for corporate earnings will remain positive. The pace of earnings growth may slow from incredibly strong levels reached in the first quarter, but we expect results will be strong enough to limit downside equity risk as investors contend with positive and negative crosscurrents. Accordingly, at some point we expect equity markets will break out of their current trading range to the upside.

Bob Doll is chief equity strategist at Nuveen Asset Management.

 

1 Source: Morningstar Direct, Bloomberg and FactSet

2 Source: Labor Department