Stocks logged modest gains in April, with the S&P 500 gaining 0.4%. While the economy continues to expand and earnings have been strong, we think some investors are concerned that the flattening yield curve may be signaling the end of the current economic cycle. In our view however, there is not yet sufficient data to support this thesis, and we maintain our positive outlook for the market.
Corporate earnings appear to have continued their positive momentum from the first quarter. As of this writing, with just over half of S&P companies having reported first quarter earnings, 80% have exceeded consensus profit expectations by an average margin of 7.3%. While some of these results are due to lower tax rates, revenues too have been strong, with 70% of companies having exceeded top line estimates. Overall, we view these results as quite robust and believe that they reinforce our thesis that strong profits can continue to carry stocks higher.
Our view notwithstanding, stocks have not reacted as positively to earnings results as would typically be the case. However, we believe that this reflects more about sentiment than underlying fundamentals. Investor expectations may have been overly aggressive with respect to the cadence of benefits from the recently enacted tax cuts. While the full impact to corporate income statements may not be as front-end loaded as investors initially believed, in our view, there is little to suggest that this is anything more than a timing issue.
Perhaps of greater concern arising from the current earnings season is the question of where we are in the current economic cycle. Caterpillar’s management team rattled markets by suggesting that its profits in the coming quarters may not reach the level achieved during the first quarter of the year. Some investors extrapolated from this comment (along with other indicators, such as the narrowing yield curve) that perhaps we are at or are nearing the peak of the market cycle. This is an important consideration with regards to ascribing an appropriate market valuation multiple.
Investors are generally more comfortable bidding up stocks to higher P/E multiples if the expectation is that earnings will be growing in future years. However, at peak earnings, market multiples typically fall as investors price in future profit declines. In our view, we do not see sufficient evidence to conclude that we are nearing the end of the cycle. While Caterpillar is a large industrial company that tends to have good visibility on macro trends, it is still just one company and its views were not confirmed by many other large industrial companies that we also follow. Moreover, the issue of the tax cut benefits not being overly front-end loaded would actually argue for a longer cycle, as the full benefits are realized over time.
Trade continues to be a focal point for investors, particularly the ongoing negotiations between the US and China. Over view is that the Trump administration would prefer not to impose tariffs on massive amounts of Chinese imported goods, and that the rhetoric in this regard was more likely a negotiation tactic. We therefore remain optimistic that a damaging trade war can be averted. There has been some trade progress made already, as China has discussed its willingness to allow foreign firms greater access to its financial and automotive industries. We also note that NAFTA talks appear to be moving forward, with Mexican officials recently expressing confidence that an agreement can be reached in the near future. We think that a successful NAFTA negotiation would boost investor confidence that a deal can be struck with China as well.
We maintain our positive view on the market. Corporate profits are robust, and we believe that a healthy economy will help to support their continued growth. Consumer confidence and small business sentiment remain near all-time highs, and the labor market is strong. We think that these conditions bode well for business activity moving forward and suggest that we are not approaching the end of the economic cycle. Given our expectation for continued profit growth, we find the market to be attractively valued and see room for stocks to move higher.
Market risks that we are monitoring include the trade negotiations with China, and while we remain optimistic that an agreement can be reached, we concede that thorny issues – including technology transfers and intellectual property rights – may yet prove to be stumbling blocks. In the geopolitical arena, oil prices moved higher following President Trump’s announcement that the US will withdraw from the Iran nuclear deal and reinstate Iranian sanctions. Oil prices had already been climbing in anticipation of this announcement, and we continue to monitor the impact of higher oil prices on consumer activity and inflation. Materially higher rates of inflation could force the Fed to accelerate its rate hiking campaign, and potentially roil capital markets. However, while various inflation metrics have come in at or near the Fed’s preferred 2% level, we are not currently seeing any indication that prices are spiraling out of control, particularly with respect to wages. Therefore, we are confident that this risk factor remains in check at present.
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