Strong earnings have provided an offset to the dysfunction in Washington. However, as we move into the fall, heightened global political risk, combined with battles on health care, taxes, and the debt limit, may fuel increased volatility in the capital markets.
On the monetary policy front, the late August Fed conference in Jackson Hole will focus on global economic conditions and the need for several central banks to normalize monetary policy. This gathering will also mark the 10 year anniversary of a monumental speech at this conference in 2007 that foresaw the great recession. Now, as then, it is important to remember that even when things are going well, caution is often warranted.
We have held a positive view towards equities for several years, but in recent months have favored harvesting a portion of the robust gains from U.S. stocks. We continue to support taking some chips off the table. Both fiscal and monetary policy is likely to be more challenged in the months ahead as positive earnings surprises may taper.
Earnings Trump Trump
For the last several months, the turnaround in corporate earnings has provided support and stability to the stock market. S&P 500 corporate profits soared at a 15 percent year-over-year pace in 2017:Q1 and, with about 84 percent of entities reporting, earnings are currently up more than 10 percent for the just-completed second quarter. If this strength is maintained it would be the first time since 2011 that the S&P 500 Index posted double-digit yearly gains in earnings for two consecutive quarters. Although the prospects for near term earnings growth are positive, with U.S. multinationals likely to receive an added boost from the fall-off in the dollar since the start of the new Administration, support for improved profit margins is decelerating.
Jackson Hole—A Path to Global Normalization
Fed Chair Yellen and ECB President Draghi will be featured speakers at the Kansas City Fed’s annual conference in Jackson Hole in late August. Both are expected to focus on the need to normalize monetary policy by removing the emergency liquidity that was injected into the system to help resolve the greatest financial crisis since the depression. The Fed is anticipated to begin reducing the size of its balance sheet shortly after the September FOMC meeting, while the ECB is expected to trim the amount of stimulus that it has provided to the European banking system starting in early 2018.
Policymakers are likely to present an optimistic outlook for economic activity and inflation. However, the heightened tensions around the world (North Korea, the Middle East, Russia, China, and Venezuela), combined with a dysfunctional start to the Trump Administration and debt limit challenges, suggest that the pathway to normalization by our leading central bankers could be bumpy. At this juncture, reflecting back to the Fed gathering a decade ago might be valuable. Even when things are going well, caution may still be warranted.
A Lesson from 2007
A 2007 speech by former Fed Governor Edward (Ned) Gramlich was the seminal event that raised the profile of the Jackson Hole Fed conference. Gramlich, who described the subprime financing market as a “Wild West” of loans that were made without proper federal government supervision, had been warning about the potential dangers of predatory lending activities and extremely soft regulations on mortgage lenders and banks for several years. In June 2007, Ned published what would become a key book on the issue. The title, “Subprime Mortgages: America’s Latest Boom and Bust,” said it all. Although several Fed members (including Fed Chair Greenspan) and many market participants did not share Gramlich’s views, his research earned him a featured presentation slot at the August 2007 Jackson Hole Symposium. Unfortunately, Ned was unable to attend the gathering for health reasons and his speech was delivered by another Fed official. Given the topic and Ned’s grave condition (he passed away about two weeks later), his paper was the highlight event at the gathering. And, for those that studied his research, it provided great insights into the challenges that eventually unfolded in late 2008 and 2009. While we do not see a similar scenario on the horizon, it is still important to remember past lessons.
The Risks Ahead
Looking forward, we believe that the rally in the stock market over the last nine months is unsustainable at its current 20+ percent annualized pace. Likewise the double digit surge in earnings that has unfolded since the start of 2017 is likely to temper towards a mid- to upper-single digit pace over the next year. This, in turn, should cause a moderation in returns from the capital markets, particularly if central bankers take steps to normalize rates and to trim the assets held at central banks. Moreover, the risk for potentially disruptive political events both domestically and internationally is higher than it was six to 12 months ago and could cause further indigestion in stocks and bonds later this year. Given this set of circumstances, we continue to favor taking chips off the table by maintaining a small overweight to equities and an underweight to fixed income.