HIGHLIGHTS
- Rough sailing after relative calm, but stocks edged out bonds in Q1.
- What’s going right?
- What is troublesome?
- Via Nova’s outlook for the stock market remains positive, but increased volatility could be the new normal.
Rough sailing after relative calm, but stocks edged out bonds in Q1.
After relatively smooth sailing and positive returns for two and a half years, the S&P 500 lost -1.22% in the first quarter (-0.76% including dividends paid). The major indexes started the year with strong gains but fell in February and March, suffering a 10% correction, and threatening the uptrend in the nine-year bull market. Worries over a possible trade war and continued monetary restraint, among other troublesome issues, overshadowed healthy economic and earnings growth. Concerns over what might happen outweighed positive developments that have happened or are likely to happen. The market dip was broad-based, with nine of eleven sectors in the S&P 500 lower, paced by telecom and staples stocks. However, pro-cyclical consumer discretionary and technology stocks gained. Small-cap and emerging market equities outperformed the S&P 500, but international stocks lagged. In the fixed income market, bond values also fell in the quarter due to rising interest rates prompted by Federal Reserve rate hikes and fears of accelerating inflation. The Bloomberg Barclays U.S. Aggregate Index fell -1.54% and all major fixed income sectors declined.
What’s going right?
Investors want to see companies grow sales and increase earnings, and the economic data and profits projections were very upbeat over the course of the first quarter. Job growth accelerated, the unemployment rate fell to a cycle low of 4.1%, wage growth improved, and consumer confidence surveys soared, suggesting the ability and the desire to buy more. Manufacturing orders and production increased as did the optimism of small and large business executives.
First quarter earnings estimates rose by 5.4% over the course of the past three months and are now projected by FactSet to increase 17.3% from the first quarter of 2017. What makes this optimism remarkable is that, during the past 15 years, earnings estimates declined an average -4.1% over the quarter. In addition, full year 2018 profits projections rose by 7.1% to an 18.5% increase over 2017. Both the quarterly and full-year estimate revisions were the largest in the survey’s history.
Several reasons wre cited for the more optimistic earnings estimates. The drop in the corporate tax rate was frequently highlighted by analysts and executives, though the precise impact is still evolving. Rising fuel prices helped lift earnings estimates for energy companies, while expectations of higher interest rates also likely contributed to the significant increase in earnings estimates for companies in the financials sector.
The projected windfall from lower tax rates and the repatriation of foreign cash due to tax reform is likely to prompt a variety of responses from companies, most all of which are positive for stock prices. These responses might include share repurchases, a new round of merger and acquisition activity, increased dividends, debt paydowns, and higher employee compensation. While some element of all of these options have been announced by companies, the final breakdown and timing is not yet known.
What is troublesome?
While the underlying economic fundamentals improved in the first quarter, potentially troublesome risks also emerged, weighing heavily on the stock markets in the first quarter. At the top of the list was the announcement of trade tariffs by the Trump administration. Few would argue that the current playing field for international trade is level, but the market concern is that the U.S. actions will trigger a like response from trading partners, which could escalate into a full-blown trade war. Such an event, if it happens, would tend to raise prices for both companies and consumers as well as hurt sales; a negative combination for revenue and earnings. Though the risk of a trade war is unknown (and unlikely in our view), the risk is being priced into the markets to varying degrees depending on the news cycle of the day.
A second worry is the pace of Federal Reserve interest rate increases. At present, the Federal Open Market Committee (FOMC) projections call for a total of three increases in the overnight policy rate, but stronger first quarter growth has caused some FOMC members to increase the appropriate number of rate increases to four. Higher rates, while typically positive for banks, would raise borrowing costs for companies and consumers.
Other troublesome issues included an announcement that the EU may impose a 3% tax on large internet companies, which would be a drag on profit margins. The disclosure that Facebook improperly controlled access and sharing of its customer data raised new concerns that congressional hearings will be called and new regulations on data privacy may follow. Tragic accidents involving driverless cars prompted temporary halts to trials while the underlying technology is reexamined. This is negative news for the technology sector and semiconductor stocks in particular.
Via Nova’s outlook for the stock market remains positive, but increased volatility could be the new normal.
Via Nova remains positive on the economy and the equity markets in 2018, but the period of high returns and low volatility has become a wistful memory. Bond investors are likely to be facing steady headwinds.
The positives outlined above suggest a favorable and supportive backdrop for earnings and stock prices, and we favor stocks over bonds. However, we have mentioned previously that market valuations are somewhat elevated, suggesting investors have discounted at least some of the expected improvement. In that sense, given some of the new potential challenges and threats, investors may wait for earnings to live up to existing expectations, which may put downward pressure on valuation metrics such as the price/earnings ratio for a time.
We see three sobering forces that may prompt investors to temper their elevated expectations: accelerating inflation, a more aggressive Federal Reserve and a looming trade war. The surge in stock market volatility in the first quarter was a surprise given the recent period of quiescence, but it quickly settled back to a higher level in line with the longer-term average. This higher volatility could be the new normal for the equity markets.