Week of April 16, 2018
Current economic events
Trade issues and the Syrian conflict received much attention last week but markets appeared to “shrug it off.” A more moderate speech by China President Xi Jinping supported markets and eased trade fears. However, a retaliatory strike in Syria by the United States, France and Britain tempered markets. The strike was in response to new chemical gas attacks on civilians by government forces under Syrian President Bashar al-Assad. Sentiment-oriented economic data are softening from high levels, perhaps indicating some concern over policy issues. In the United States, the National Federation of Independent Businesses Small Business Optimism survey weakened from last month’s reading, which was the highest in 34 years, while the preliminary April survey of consumer sentiment from the University of Michigan moderated from the highest reading since before the financial crisis. Across Europe, sentiment indicators from Sentix also weakened, with respondents likely showing caution in the face of previously strong data and amidst global trade concerns. While in the near term these are likely to give stock markets some pause, we believe the U.S. and world economies will, in general, continue their economic expansion.
Inflation data continue to be closely watched by investors for signs of acceleration, which could prompt more aggressive Federal Reserve (Fed) interest rate hikes. Both consumer and producer price inflation ticked higher, according to year-over-year observation for March, both for core prices as well as the more volatile food and energy components. Despite the rise in energy prices, inflation gains were not observed globally. Price gains weakened in China, Japan, Brazil and India and were disappointing in Europe, versus consensus economist expectations. We still see indications of inflation pressures in the United States. However, these pressures are likely to be limited, with the Fed raising interest rates and more limited pressures globally.
U.S. equities trended mostly higher last week, with first quarter earnings releases underway. For the week, the popular, broad-based U.S. indices advanced between 2.1 percent and 2.9 percent, with eight of 11 S&P 500 sectors posting gains. Only the interest-sensitive Utilities, Real Estate and Telecom Services companies retreated. Year-to-date performance continues to lag historical norms. As of close on April 6, the S&P 500 is down 0.6 percent for the year, with only two of 11 sectors (Information Technology and Consumer Discretionary) posting positive returns. On balance, cross-currents between fundamental, sentiment and technical trends present a backdrop for positive, yet more subdued, future returns.
The fundamental backdrop remains generally constructive for equities, bolstered by increasing earnings, short-of-extreme valuations and generally restrained inflation.
- Earnings are increasing due to improvement in economic growth around the world and, in the United States, tax reform. Consensus estimates for 2018 and 2019 have remained approximately $157 and $170, respectively, since the end of January, according to Bloomberg and FactSet. This reflects year-over-year earnings growth of roughly 18 percent in 2018 and 10 percent in 2019. First quarter releases are of immediate focus, with roughly 75 percent of S&P 500 companies slated to release results over the next three weeks. Expectations are relatively high, evidenced by Friday’s sell-off of financial companies following generally strong quarterly releases from high-profile banks with few notable areas of concern.
- Valuation is likely to be more of a headwind than a tailwind in the second half of the year when investor focus shifts to 2019 and the estimated slower pace of year-over-year earnings growth. The S&P 500 closed April 6 trading at approximately 21 times and 17 times trailing 12-month and 2018 estimates, respectively, which are levels considered to be elevated yet short of extremes. The longer-term price-earnings average multiple on current year estimates is roughly 15 times.
- Inflationary pressures tend to cause price-earnings multiples to compress, resulting in lower stock prices. While inflation is currently not an issue, it does appear to be looming on the horizon and may become an issue in the second half of the year. At a minimum, it seems most probable that any market upside will be driven more by earnings growth versus multiple expansion.
Our published S&P 500 year-end 2018 price target is 3,000, based on a multiple of 19 times to 20 times our 2018 earnings estimate of $155 per share. That would be roughly 13 percent above the April 6 close. This price target may prove to be optimistic should sentiment wane and market technical trend lines deteriorate. Any upside to earnings is likely to be offset by multiple compression as a result of a slower rate of earnings growth in 2019 over current year levels. We intend to review our assumptions and price target at the conclusion of first quarter releases. In general, we continue to maintain a growth bias, favoring sectors and companies growing revenue faster than peers while operating in market segments growing faster than the broad economy.
Fixed income markets
U.S. Treasury yields have increased as easing trade tensions bolstered risk appetite, Fed meeting minutes noted an improved economic outlook and inflation data accelerated. Treasury yields should continue rising gradually this year fueled by the Fed, stable growth, rising inflation expectations, robust Treasury issuance and diminished foreign investor demand. With sentiment extreme and technical resistance at 3 percent for the 10-year Treasury, however, the move higher could take time to resolve and is likely to be choppy in the interim. We advocate for a below-benchmark duration target for most diversified portfolios.
Investor expectations have room to move higher to coincide with Fed expectations, supporting gradually rising yields. The March Fed meeting minutes were slightly hawkish. We expect two additional rate hikes in 2018, for a total of three, although four is becoming increasingly plausible. While the market is pricing in a total of three for 2018, expectations for 2019 indicate 1.5 hikes compared to the Fed’s own guidance of three. Consumer and Producer Price Index (CPI and PPI, respectively) data released last week indicated accelerating inflation, further validating the Fed’s stance of continued gradual rate increases.
We are maintaining a balanced view of credit versus Treasuries. Investment-grade and high yield corporate credit markets performed well last week. Credit spreads (the difference between yield of a riskier bond relative to the yield of low risk U.S. Treasuries) tightened notably, signaling subdued bond market concern relative to the more volatile equity markets. Risk appetite improved based on optimism around trade negotiations and earnings season. Investment-grade debt remains a valuable component of a diversified portfolio given its low correlation to equities. We view the risk/reward of high-quality credit versus Treasuries as balanced.
Real estate markets
Publicly traded real estate investment trusts (REITs) declined 0.93 percent last week and underperformed the broader market by 3.02 percent. For the year, REITs now trail the broader market by 750 basis points. A return to “risk on” and higher rates were the likely reasons for the underperformance. In the absence of any significant new data, REIT relative performance will likely be driven by whether the market is in “risk on” versus “risk off” mode. Defensive sectors, like REITs, will generally perform poorly on a relative basis in the former market environment and better in the latter.
Crude oil prices increased 8.6 percent last week and traded at the highest price in more than three years. Prices were able to break out above the top of the recent range and closed at $67.39 per barrel. Global geopolitical issues more than offset record U.S. production and an inventory increase domestically. In the United States, production hit another cycle high of 10.53 million barrels per day, inventories of crude increased by more than 3 million barrels, and the rig count jumped to 815, the highest level in three years. Although the crude market is fairly well supplied right now, OPEC production cuts have reduced the global inventory surplus. Accordingly, geopolitical tensions are now highly influential to prices in the near term.
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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.
Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.
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