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Headwinds for The U.S. Stocks Have Risen But Tailwinds Also Exist

It’s been a crazy spring weather-wise for much of America, and the U.S. stock market is dealing with windy conditions as well, making it more difficult for investors to get a clear picture of market direction. Stock market indexes have now had a successful retest of the early-February lows, but selling pressure may not yet be exhausted. In our experience, the average corrective phase historically has brought more duration and still-sharper declines. Geopolitical conflicts, trade worries, debt/deficit concerns, tighter financial conditions, a softer first quarter for the economy, elevated earnings expectations, and midterm elections are some of the things that could push stocks temporarily lower, while a positive resolution to some of these issues could charge up the bulls.

Additionally, investors have expressed concerns about the flattening yield curve; although it’s typically only well after an inversion do risks of a recession become heightened. A break below 50 basis points in terms of the difference between the 10-year and 2-year Treasury yields doesn’t always lead to recession; and in fact has been historically accompanied by positive equity market performance.

Temporary reprieves?

A positive side-effect of three months of volatility is that investor sentiment has moved into the range that is associated with the best annualized gains for stocks, according to the Ned Davis Research Crowd Sentiment Poll. And there are plenty of tailwinds that can also help to elongate the bull market; with tax cuts for both consumers and businesses coming into effect; a solid corporate earnings picture, with year-over-year growth for the S&P 500 currently expected to surpass 20% this year, according to Thomson Reuters; still relatively low interest rates; and inflation that is tame enough—albeit rising—to keep the Federal Reserve from having to tap the brakes more strongly.

Economy still supportive

Although first quarter U.S. real gross domestic product (GDP) growth was better than expected but still a bit soft, coming in at a 2.3% annualized, we have discussed many times before the tendency for the first quarter to be softer-than-trend due to myriad seasonal distortions; so we aren’t too concerned with that reading, and actually somewhat encouraged that the traditional soft first quarter was better than expected. Other economic data has been strong, in concert with continued strength in the Index of Leading Economic Indicators -- including industrial production, durable goods and housing data.

As does industrial production

Despite the very strong earnings season so far, stocks have at times struggled, reflecting an elevated expectations bar and the likelihood that at least some of the good earnings news was already priced into stocks. There remain tailwinds which could push growth back to trend and keep earnings from faltering: The tax cuts for consumers and businesses are just coming into effect, and repatriation efforts should begin to pick up now that the Treasury Department has issued guidance on several outstanding issues. This has translated into elevated consumer and business confidence, which had generated hope for a strong capital spending (capex) cycle. However, some leading indicators of capex have recently rolled over; while at the same time an increasing number of companies have cited trade-related uncertainty in their earnings conference calls; so there may be a pause in the capex cycle.

Tailwinds could lead to headwinds

A mostly-positive economic backdrop has raised inflation and inflation expectations, and could push the Fed to move more aggressively. Commodity prices have moved higher (more on the rise in oil), the labor market remains tight, and increased fiscal stimulus has causedseveral key inflation indicators to move above the Fed’s 2% target.

The minutes from the most recent Federal Open Market Committee (FOMC) meeting indicated that it wasn’t overly concerned about inflation at this point; although they cited tariff concerns as one basis for the pace of rate hikes to remain gradual. We don’t expect a hike at the May FOMC meeting, but a June hike is a near-certainty at this point according to the fed funds futures market.

Political winds are blowing

As is typical, we expect a continued rocky road between here and the midterm elections.  Historically the average loss of House seats in the first midterm for a newly elected president has been 29 according to Strategas Research; so that potential for turnover can help contribute to investor nervousness. The average maximum drawdown by the S&P 500 during midterm election years since 1950 has been 17%, with weakness concentrated in the first three-quarters of those years. But a positive caveat is that the average subsequent one-year performance from the trough of the drawdown has been 32%. We certainly can’t be sure that history will repeat itself—especially in an era like this—but any election-related weakness could be followed by a rally thereafter.

So what?

Headwinds for stocks have risen but tailwinds also exist, resulting in a more tumultuous environment. We believe there are enough positives to keep the bull market going but gains are likely to be slower in coming, volatility is likely to remain elevated and discipline to a long-term plan will be crucial. Avoid overreacting to the barrage of news and focus on the items that could change the actual fundamentals of the economy.

 

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.

The Consumer Price Index (CPI) is an index that measures the weighted average of prices of a basket of consumer goods and services, weighted according to their importance.

The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.

The Business Confidence Index is based on enterprises' assessment of production, orders and stocks, as well as its current position and expectations for the immediate future. Opinions compared to a “normal” state are collected and the difference between positive and negative answers provides a qualitative index on economic conditions.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Content provided by Charles Schwab, Hong Kong
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