Dour Sentiment, Stable Economy
October 18, 2016
Markets Enjoyed The Summer
The third quarter, which ended September 30th, was remarkable for how uneventful it was. Stocks broadly rose through the summer, with the S&P 500 Index posting a gain of 3.3%. U.S. stocks hit all-time highs in August before backing off moderately through September. Over the summer, U.S. equity markets went two full months without a daily move of 1% or more, a remarkable stretch of stability, especially considering that this period came right on the heels of the uncertainties that the June Brexit vote stoked in Europe.
Investors Look to Election, Fed and Earnings
As we move into the final quarter of 2016, investors have three main topics of interest: the November election, the action (or inaction) of the Federal Reserve on the question of rates and corporate earnings.
Second, investors continue to watch closely for clues as to whether or not the Fed will raise interest rates this year. The Fed, according to the recently released minutes of its September 20-21 meeting, almost hiked rates-but did not. Apparently there were some disagreements over the proper timing of a hike, as several Fed officials are hoping to see more improvement in the labor market. Right now 74% of economists surveyed by the Wall Street Journal expect a rate increase in December. The Fed directly controls only short interest rates, however, so a Fed Funds rate increase is by no means a guarantee that long rates will rise. In fact, since the Fed first raised rates by 0.25% last December, the ten-year U.S. Treasury note yield has actually decreased from about 2.3% then to 1.75% today. Rock-bottom interest rates are a product of sluggish demand and aging populations across the developed world.
Finally, investors want to see if companies in the S&P 500 are able to generate earnings growth this quarter. If earnings do in fact decline, it will be the sixth consecutive quarter of declining aggregate corporate earnings. By far the largest culprit in the earnings decline has been the energy sector. Oil prices bottomed at around $30 per barrel in January of this year and are now sitting at $50. Thus, if the price holds around $50, energy companies may be able to show some growth (off a lower base) going into 2017. Financials are the other laggard. With interest rates so low and the spread between short rates and long rates so tight, financials have struggled in recent quarters. Higher short rates, if they come with a wider spread, would be greatly welcomed by the banks. If the energy and financial sectors are able to stage a turnaround, solid earning growth may well resume for the S&P 500 in 2017.
Stocks Remain Bouyant
When corporate earnings decline but stock prices stay flat or go up, then price-to-earnings (P/E) multiples increase, reflecting the fact that investors are paying a higher price for a given level of earnings. Because U.S. stocks are roughly trading at the same level that they reached in May of 2015 and because aggregate earnings have declined since then, the P/E multiple has increased. U.S. stocks now fetch 18 times analysts' earnings estimates for the coming year, which is higher than the long-term average of 15 or so. The market's pricing of stocks may be embedding an expectation for an earnings recovery in 2017 and/or it may be saying that relative to bonds, stocks still offer pretty decent value.
The U.S. economy continues to plod along in a positive direction, but as yet is showing few signs of a long-hoped-for acceleration. On the face of it, most of the general economic statistics are relatively sanguine. The unemployment rate is just 5%, although this headline number does not account for the significant number of people that have chosen to leave the workforce or those that are working low-wage jobs beneath what their skill levels might command. Stocks are within a few percentage points of their all-time highs, real estate prices have been rising and total household wealth continues to increase nicely. Food and energy prices are also very low. Broadly speaking, the financial situation for the average American continues to improve.
Many bonds around the world are trading at record-high prices (and record-low yields) in a nod to the aforementioned dour sentiment in the U.S. and caution in Europe as Britain's exit from the European Union begins to take shape. A shift toward protectionism seems to be looming as populist political parties gain traction in many countries and global trade is increasing disparaged as a cause of poverty rather than source of prosperity.
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Photo credits: (1) flicker.com/Ally Aubry, (2) kenteegardin via Foter.com / CC BY-SA