It’s been a volatile summer and autumn for investors, as Wall Street grapples with considerable uncertainties surrounding the presidential election, monetary policy, bond yields, the dollar, earnings, and China. Nevertheless, the U.S. stock market—as measured by the S&P 500 Index—has persevered and is up nearly 5% so far this year.1
With two more months to go in 2016, it remains to be seen whether global equities can build upon their recent momentum. With that in mind, here are several of the themes that I think are most likely to influence the investment landscape as we approach 2017.
The third-quarter earnings season is under way and is off to a mostly positive start. Despite a few notable earnings misses that have grabbed headlines, the typical seasonal pattern has been unfolding. Earnings estimates typically decline heading into quarter-end (by an average of 800 basis points, or bps, during the preceding six months), but then rebound during the actual reporting season (by an average of 300 bps). This reflects the historical tendency of companies to under-promise and over-deliver on earnings estimates.
So far, that’s what’s been happening. The year-over-year earnings-per-share (EPS) growth estimate for Q3 2016 has already climbed from a low of -1.6% to its current level of -0.4% (see chart below). Therefore, it appears the earnings cycle is clearly bottoming. In fact, if the seasonal pattern persists, we could easily see EPS growth of around +2% when the Q3 season is over. That would make Q3 the first quarter in six to exhibit positive earnings growth. And Q4 looks even better at nearly +6% (blue line in chart).
While the quality of earnings still leaves something to be desired (they’ve been driven more by financial engineering than by organic profit growth), it’s encouraging to see that the overall growth rate of earnings has stabilized.
|2.||Taper tantrum 2.0?|
In last month’s commentary, I wrote that it felt like we were reliving the taper tantrum of 2013, when the U.S. Federal Reserve (the Fed) signaled its intention to scale back (“taper”) its asset purchases. When the Fed made that announcement, stocks tumbled and bond yields rose sharply. Today, history seems to be repeating itself, albeit in a smaller way. The 10-year Treasury yield has risen half a percentage point from its 2016 low of 1.3% to last week’s high of 1.8%, and the S&P 500 Index is down 4% from its high point of the year, set on August 23. A rising yield environment in the absence of economic growth is one of things that investors fear the most, especially when rates are this low.
One reason why it’s such a concern is that expected cash flows or earnings need to be discounted by a discount rate to determine fair value (there are a number of ways to calculate a discount rate; I prefer to use the sum of the 10-year Treasury plus the equity risk premium2). When earnings growth is robust, changes in the discount rate don’t have that much impact. But when earnings growth is poor, changes in the rate have an outsized impact on valuation.
Is the recent increase in bond yields the start of a major new uptrend, or just a temporary bump in the road on the prevailing movement toward lower yields and ongoing stock market growth? It all depends on whether nominal economic growth is picking up, and whether that growth is generated by higher inflation, higher real growth, or a combination of both.
Coming back to my valuation model, equities can easily withstand a pickup in rates if earnings growth also improves (as it may be doing). Based on my fair value estimate for the 10-year Treasury, we could see its yield move to 2% or more. As long as earnings growth picks up—even if only to the low single digits—the market should be OK. But if growth does not materialize, then yields can probably only rise so much before upsetting the delicate balance between growth and rates.
Having said that, it’s looking more and more like Treasury yields have seen their lows for a while. Why? First, both global growth and inflation seem to have stabilized and may even pick up a bit in 2017, especially with all the election-season emphasis on fiscal stimulus. That would argue against new lows for global yields for now. Second, the recent low of 1.32% (immediately post-Brexit) marked the level at which the 10-year yield fell to the level of other G73 sovereign debt yields (on a currency-hedged basis). That’s an important development, because if non-U.S. investors no longer get the advantage of higher rates versus their home market after hedging out their currency exposure, it could make Treasury buying less attractive.
If the yield has indeed bottomed, it could mean that the crowded low-volatility, high-dividend phenomenon may have reached its limits for a while. So, we could see the stock market rotate back toward more cyclical and growth-oriented sectors.
The setup heading into the Fed’s September meeting was that the data would have to be strong enough to support a rate hike (it wasn’t). But for December, the data will have to be weak enough for the Fed not to hike. That’s a different standard. Currently, the market puts the odds of a 25 bps rate increase in December at 68%.4 But if the current mini taper tantrum persists or gets worse, the Fed might have to yet again put its rate-hike plans on hold.
Nevertheless, it appears that the Fed will raise rates in December unless things unravel between now and then. In either case, the Fed faces an interesting conundrum. Since the financial crisis ended, the jobless rate has been cut in half (from 10% to 5%) and is now pressing against the Fed’s assessment of where the full employment threshold is (beyond which things become inflationary). Yet real GDP growth continues to sputter along at a mere 1.5% to 2.0%, while earnings growth is negative. It’s a real dilemma for the Fed and its traditional orientation toward balancing the inverse relationship between the level of unemployment and the rate of inflation.
The British pound continues to weaken, the Bank of England continues to ease its monetary policy, and there is increasing talk of fiscal stimulus on the horizon. Yet the FTSE 100 Index—a benchmark of U.K. stock performance—is back at its old highs. So much for the conventional wisdom that Brexit would spell doom and gloom in the U.K. It also goes to show that stocks love reflation, no matter what the cost, and that the U.K. policy trifecta of currency devaluation, monetary easing, and fiscal stimulus could well become the model for other developed countries facing stagnating growth, aging populations, and excessive debt levels.
Improved economic stability in China has been a big part of the resilience we’ve seen in global equities lately. China has adopted the same policy trifecta that the U.K. is flirting with: monetary stimulus, fiscal stimulus, and currency devaluation. The People’s Bank of China is funding the commercial banks, the government is in full-on deficit-spending mode, and China continues to allow its currency to slide, seemingly without any of the nasty contagion that was caused by similar-magnitude devaluations in August 2015 and January 2016.
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