Key Points
• We believe investors are overly complacent about the state of the global economy and the political backdrop.
• We remain cautiously optimistic toward equities, but think the pace of recent gains is unlikely to persist and that risks will rise this year.
Can the Equity Rally Continue?
Equity markets have increased since the U.S. elections for two principal reasons: optimism over a pro-growth legislative agenda from Donald Trump and improving U.S. and global economic and earnings growth.
The second factor actually began emerging in mid-2016. The S&P 500 Index advanced close to 7% between its summertime low and Election Day, and has subsequently risen nearly 10%.1 Since this time last year, when investors were focused on deflation and recession risks, the S&P 500 has climbed nearly 30%.1 Bond yields have also risen significantly in recent months: the 10-year Treasury yield climbed close to 50 basis points since the election and more than 100 basis points since the mid-2016 lows.1
Simply put, we do not believe this pace of gains is sustainable. We think that economic growth will continue improving and the economy and markets will benefit from the legislative backdrop. But the intense pace of gains implies that investors believe both trends will persist without interruption. We think this is unlikely and expect bumps along the way in economic and earnings data. The political environment will also likely provide its share of setbacks.
Investors May Be Looking Past Economic Risks
For several years, the U.S. economy has benefited from a Goldilocks scenario of low inflation and supportive monetary policy that has allowed slow, but consistently positive growth. We think the economy is now moving into a slightly higher gear. Falling unemployment and slowly rising wages are boosting consumer spending. Corporations are increasing spending levels and engaging in equity-friendly practices such as dividend increases and merger activities. Additionally, while the Federal Reserve is starting to raise interest rates, policy remains extremely accommodative and should help economic growth.
Outside of the United States, we also see reasons for optimism. Brexit risks notwithstanding, the eurozone appears to be recovering. In China, fears of a hard landing have receded and worries over a disorderly currency devaluation have faded as Chinese policymakers have ramped up their own fiscal stimulus to help the economy.
And we would also point out that the corporate earnings backdrop is also improving. A key drag on earnings—rapidly falling oil prices—has probably run its course. And the quickly rising dollar remains present but has moderated. At some point, however, conditions for continued growth may become trickier, and the economic environment will likely grow more uncertain. Inflation appears to be climbing slowly and interest rates have probably bottomed. A stronger dollar also presents a risk. Together, these factors may conspire to tighten financial conditions. We don’t expect these trends to emerge quickly, but believe the Goldilocks environment driving growth will likely begin fading by the end of 2017.