Market Memo: Waiting for Godot can be frustrating

07-19-2017

With earnings season fully underway and without any real progress on four key drivers for which investors have been patiently awaiting—fiscal reforms, interest-rate increases, deregulation and economic acceleration—the post-election ride to new highs has stalled and a correction may be at hand. This, in our view, would be a welcome development. Because at the end of the day, we still expect progress across all four fronts in the fall and remain confident in our respective 2017 and 2018 year-end S&P 500 forecasts of 2,500 and 3,000. So be patient, as frustrating as that may be. And if there is a dip, buy it.

Where the four key market drivers stand:

  • Fiscal reforms: Near-term ugly, medium-term positive The sausage-making process on Capitol Hill has been a horror show, with an all-Republican federal government unable to quickly push through any of the growth-inducing fiscal reforms (Obamacare repeal-and-replace, tax reform and infrastructure spending) that drove the post-election surge. The latest example? The announcement that Senate leaders are giving up repeal-and-replace legislation in the current session. But while most political analysts are carping about this failure, we see a silver lining: fear, the great motivator. Indeed, a repeat debacle on tax reform surely will result in massive Republican losses in the 2018 midterm elections. So while we may have liked to see repeal-and-replace happen first so that Congress could move on to tax reform with momentum, we’ll settle for moving on to tax reform with desperation. Our call: by late fall, markets will begin to see that an early 2018 tax bill is highly probable, and with it, economic and earnings forecasts for 2018 and 2019 will lift. Hence, near-term ugly, medium-term positive.
  • Interest-rate increases: Gradual grind higher is the ‘new Goldilocks’ Part of the “Trump Trade” was a big move up in financials on expectations that higher economic growth would drive the Fed to accelerate interest-rate hikes, and with it, all-important bank net interest margins. What we’ve discovered since is that the deflationary forces in the new economy (global competition, automation, disruptive technologies and business processes such as Lyft) are muting the late-stage inflationary pressures typical at this stage of a cycle. This is most evident in the 10-year Treasury yield, which as of this writing is trading at 2.27%, well off its post-election high of 2.62%. Although this disappointment relative to heightened expectations may be frustrating, banks’ net interest margins have risen modestly the past 12 months, and the Fed is still in hiking mode, albeit at a dovish pace, with the next increase likely in December. We view this gradual path upward as a medium-term market positive, whatever the short-term frustrations. As rates grind higher, so will bank earnings. And if the 10-year yield is capped this cycle at 3-3.5% (our new base case), all the better! Such a level would support P/E multiples, tempering concerns the market is too expensive. So, a gradual grind higher in rates may well be the new Goldilocks.
  • Deregulation: ‘Show me’ takes time The pro-business tone of the Trump administration, and the promise of a business-friendlier regulatory branch extending from it, has boosted business and consumer confidence to near cycle highs. The complaint now is the old Missouri cry, “Show me!” “Show me” will take time, and will be less visible by definition (unenforced or repealed regulatory rules never get the same attention of exciting new ones). Nevertheless, we see the direction as set and the course clear, with an improved regulatory backdrop supportive of better growth by 2018 and more importantly 2019.
  • Economic and earnings acceleration: It’s beneath the surface; just be patient This is the most important of the four key drivers because it represents the bottom line: earnings. Despite the market’s current malaise and the bears’ clamor for “hard numbers,” the reality is progress is indeed happening. For example, the consensus forecast for Q3 GDP growth actually has risen modestly in the last few months, to Federated’s previously above-consensus forecast of 2.5%. Importantly, other recently released key indicators of economic health, such as the manufacturing and services ISMs and nonfarm payrolls, are at strong levels and beating expectations. This earnings season has been solid so far, just not wildly so. Indeed, consensus expectations for 2017 S&P earnings have held this year at roughly $130, far better than the normal yearly pattern of gradual declines through the year as “reality” sets in. Another earnings driver that could kick in by the second half is the weaker dollar, which today moved to a new 2017 low on the back of the failed health-care reform initiative. Importantly, next year’s expected earnings of $140 have little by way of economic acceleration, tax reform or dollar weakness in the numbers. So if we do get progress on these fronts, expect the market to discount that with higher stock prices.

Let patience be a virtue
Don’t lose the forest for the trees. Sure, we’d like fiscal reforms to come quicker. But we’re still only seven months into a new administration—it just feels longer! Sure, banks would like their net interest margins to explode higher. But a steady rise is still a rise. Sure, we’d like to see deregulation take effect immediately, but a relaxation in rules and enforcement takes time to filter through bureaucracies to the bottom line. And sure, we’d like to see GDP growth reach a three handle, as many thought might be possible during the post-election celebrations. But even mid-2 numbers are an improvement.

In sum, we remain optimistic—and ahead of consensus—that all four drivers eventually will carry the market to our targets for this year and next. Stocks are in sort of a pause mode now, with a 3% to 5% pullback possible through the rest of this summer. We counsel patience and recommend that investors remain overweight equities, and particularly cyclical and financial stocks. And if a dip does come, buy it.