16 May 2016
Modest Growth is a Good Environment for Potential US Stock Gains
The US stock market rally from the lows in February to near-record highs may have investors scratching their heads. Economic data has been mixed, the international outlook has calmed for now but risks remain, and the ongoing earnings reporting season has been relatively poor—all the makings of a stock market rally?
Remember this—it’s rarely the absolute level of any reported data that drives stocks; rather it’s how results fare relative to expectations and the rate of change. As we’ve often noted, better or worse tends to matter more for stocks than good or bad. Low expectations are often great expectations, much as we’ve seen over the past few months. Coming into the first quarter earnings season, analysts were expecting a fairly miserable showing; but the expectations bar was set too low and in many cases companies have outperformed expectations. For example, while the results were uniformly weak across a number of measures for major banks, they weren’t as bad as had been expected, resulting in a rally for the financial sector.
This dynamic can only go on so long, however, as besting expectations also tends to raise forward-looking expectations, resulting in the economy and companies having to deliver better results. Investor sentiment has moved back into the extreme optimism zone according to the Ned Davis Crowd Sentiment Poll; the rally has raised valuation concerns given weak profitability; and we are about to enter a season that has tended to be a bit weaker for stocks.
We remain neutral on U.S. and global stocks and suggest investors check their allocations for possible rebalancing opportunities. Pullbacks are likely, and necessary, but modest economic growth and continued low interest rates should help to keep the overall trend moving higher.
The chicken or the egg?
It hasn’t just been earnings expectations which have been bested. If you think back to the beginning of the year, many investors were worried about a U.S. recession, while the consensus was that the dollar would continue to move higher alongside Fed rate hikes and looser policy by global central banks. Additionally, predictions for the price of oil were starting to move toward the $20/barrel mark, and manufacturing and global trade were feared to be falling off a cliff. Those concerns have abated courtesy of the dollar upward trend being broken and the attendant rally in commodity prices, which provided support for stocks. We noted late last year that the dollar has had a history of weakening in the six months following initial Fed rate hikes—not necessarily what the consensus might believe.
In terms of the US economy, we expect real GDP to rebound in the second quarter after the anemic 0.5% growth in the first quarter. This has been a fairly consistent seasonal pattern over the past decade. But there does appear to be a limiting upside to oil prices, with major oil producers unable to agree to any limits on production, and shuttered U.S. rigs able to be brought back online relatively quickly. However, we may be in a “sweet spot” for oil, where it’s not moving lower and causing more damage to the energy sector, but also not moving so high as to substantially raise costs for consumer and businesses. Manufacturing appears to have improved, with the Institute for Supply Management’s Manufacturing Index moving into territory depicting expansion, while the leading new orders component jumped sharply. But on the flip side, industrial production and capacity utilization have both fallen to levels indicating higher recession risk. Finally, housing is presenting a mixed picture which we expect to improve into the traditionally strong spring/summer selling season, which could provide a tailwind to economic growth.
Fed and investor expectations seem disconnected
The Federal Open Market Committee (FOMC) met investor expectations when it left monetary policy unchanged at its recent meeting, but expectations for future moves remain divergent. The Fed is still forecasting a couple of hikes to come in 2016, while the market expects no more than one at this point. We remain in the two hikes camp, with the first one possibly coming as soon as June, barring any significant deterioration in economic data or sharp increase in global market volatility between now and then.
Expectations and inflection points matter in investing, often more so than the overall level of any given data set. The besting of low expectations has helped stocks to move higher, but the bar has been raised so we continue to suggest a neutral allocation toward U.S. stocks.
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.