Keeping It Simple — Growth and Earnings Still Driving Equities

November 3, 2017  | by Ryan Driscoll, Michael Strauss

Market Commentary

Summary

  • The U.S. economy has moved into a stronger growth mode. Even with the negative impact from hurricanes, real GDP growth expanded at a 3.0 percent pace in 2017:Q3, after a 3.1 percent advance in 2017:Q2. This represented the first time since 2014 that the economy registered back-to-back quarterly gains of three percent or more.

  • In similar fashion, the latest quarterly corporate revenue and profit readings are consistent with the solid macroeconomic reports and the continued strength in the equity market the last several months.

  • Although monetary policy was held steady following the latest FOMC meeting, the recent economic data support further normalization of both interest rates and the Fed’s balance sheet in late 2017 and 2018. These actions, in turn, could eventually temper returns.

Signs of a Stronger Economy

A robust 8.6 percent gain in business equipment investment, combined with a respectable 2.4 percent increase in real consumption and a 2.3 percent gain in exports were the key catalysts to the continuation of the three percent real growth pace in the third quarter. Moreover, the gain in real GDP would have been even stronger if it were not for the hurricane-induced hit to both business investment in structures and residential investment which fell 5.2 percent and 6.0 percent, respectively. These two components are likely to stage a significant rebound in the next two to three quarters and should be catalysts to a continuation of solid domestic economic activity. A rebound in U.S. capital expenditures has unfolded and business spending could receive an added boost if Congress can pass a tax plan. With wage and benefit costs showing signs of a modest reacceleration and the sub 4.2 percent unemployment rate sparking fears of labor shortages, the Fed is likely to continue to normalize interest rates in late 2017 and early 2018.

Another Quarter of Robust Profits

On a similar note, the latest earnings reports once again revealed upside surprises, confirming that corporate America benefited from the improvement of top line revenues. Through the morning of Thursday, November 2nd, 384 (77 percent) of reporting companies in the S&P 500 index have released 3rd quarter 2017 earnings. Of those, 296 (77 percent) have surprised to the upside on an earnings-per-share basis with approximately 72 percent reporting positive growth. The overall average earnings growth rate is 8.6 percent at this point in the season. The reported sales-per-share figures show that 306 (80 percent) companies have reported an increase in sales and the average sales growth for all reporting companies to-date is 5.72 percent. Interestingly, this fits in line with the rebound in nominal GDP from 4.1 percent to 5.2 percent in the quarter.

...the second stage of the normalization in monetary policy has begun as the Fed is now actively taking steps to reduce the size of its balance sheet...

Changing of the Guard at the Fed

A multi-dimensional changing of the guard is unfolding at the Fed, which will include both leadership and process changes. The focus has centered on the potential replacements for Chair Yellen and Vice Chair Fischer, with Fed Governor Jerome Powell and Stamford Professor John Taylor as the leading candidates for these two slots. The announcement that the next Fed chair will be Jerome Powell is not a major surprise. Powell, a current Fed governor, should receive strong approval and is likely to continue the normalization policy stance that has been orchestrated by Yellen and Stanley Fischer, the recently retired vice chair. However, with several vacancies remaining at the Fed’s board of governors, it will be interesting to see how President Trump fills the remaining seats.

Equally important, the second stage of the normalization in monetary policy has begun as the Fed is now actively taking steps to reduce the size of its balance sheet. This will cut the amount of excess reserves in the banking system which, when combined with additional rate hike adjustments and the potential increase in the budget deficit towards $1 trillion per year, is likely to continue to put upward pressure on interest rates. In fact, by late 2018 or early 2019 the combination of increased Treasury debt issuance and the liquidation of Treasury holdings by the Fed could result in the market having to absorb an average of $5 to $6 billion in Treasuries every single business day.

As we have expressed for several months, the days of extremely easy monetary policy are coming to an end. These actions, combined with the events in Washington to try to implement fiscal policy changes, could fuel a bit more uncertainty and volatility in the capital markets. The potential deluge of new Treasury supply for capital market participants could put upward pressure on market interest rates, which, in turn, could be the catalyst that eventually trims equity valuations. Given these events, we continue to believe that it is important to periodically rebalance portfolios back towards long term targets.

Authors

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Michael Strauss is Chief Economist at Commonfund. Michael has over 30 years of institutional financial services and investment experience. Previously, he held positions as a top-ranked chief economist and financial market strategist with Sanwa Securities, Yamaichi International (America) Inc., and UBS Securities. Michael received the Market News Forecaster Award as the most accurate "Wall Street" economist for 1997 and has been a speaker on CNN and CNBC and, over the years, has been quoted by Reuters, Dow Jones Capital Markets, The New York Times, The Wall Street Journal, and Barrons. He has been a faculty member at the Treasury Institute for Higher Education (TIHE), the Tax Institute for Colleges and Universities (TIFCU), and the National Association of College and University Business Officers (NACUBO) Conference. He holds a B.S. degree with distinction from Cornell University and an M.B.A. with distinction from New York University.
Michael H. Strauss
Chief Economist
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Ryan Driscoll is responsible for trading and investment analysis at Commonfund Asset Management Company. Prior to joining Commonfund, Ryan worked at Sailfish Capital Partners, a multi-strategy fixed income fund, where he served on the Emerging Markets team. Prior to that, he was on the fixed income team at Grantham, Mayo, Van Otterloo & Co. and was an equity/fixed income trader at Loring, Wolcott and Coolidge, in Boston. Ryan received his B.S. in Finance and M.S. in Global Financial Analysis (with Distinction) from Bentley College. He is a CFA Charterholder and is a member of the Boston Securities Analyst Society and CFA Institute
Ryan Driscoll
Director, CFA
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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.