Market Memo: Despite rising risks, bullish thesis intact

04-03-2018

As we begin the second quarter, markets sit at a critical juncture. Economic growth remains strong, with jobless claims at a 45-year low, consumer confidence at an 18-year high and ISM manufacturing just off a 14-year high. Yet the S&P 500 is 10% below its January high, as markets just can’t seem to shake their recent skittishness, with every few weeks bringing another reason to worry. In mid-March, it was trade wars. In the past week, Big Tech and Big Data have fallen under a cloud. Nonetheless, Federated’s equity team remains bullish, as market events have yet to undermine the three key pillars of our bullish thesis:

  • The first-quarter earnings season isn’t just supposed to be good, it’s supposed to be the best in seven years. S&P earnings are projected to have grown 17% in the year’s first three months, aided by the new tax law’s lower top-line rate. All 11 sectors are forecast to post year-over-year profit growth, with increases in seven sectors expected to be in the double digits, led by Energy, Materials, Technology and Financials. We anticipate the rest of the year also will be good for earnings, just not as strong as the first quarter. The key question will be whether the Q1 season that kicks off in a few days captures the attention of investors and shakes off the willies of the past few months.
  • Inflation and interest rates may rise, but not soar. Since late January’s inflation scare, price data has been relatively benign, helping Treasury yields fall significantly back to 2.74% after the 10-year inched close to 3% in mid-February. We do expect inflation to build over the coming months, in part because exceptionally weak readings from a year ago will be rolling off. That alone could be enough to push core PCE to a 2-year high of 1.9% later this spring, lifting the 10-year yield back toward 3%. By year-end, it’s possible core PCE could meaningfully exceed 2%, pushing past the Fed’s target for the first time since 2012. We still believe that the push higher in inflation is likely to be more a grind than a sprint, which should be supportive of stocks, but the risk of accelerating inflation has risen.
  • The Powell-led Fed so far seems OK with continued measured steps toward policy normalization. It gave the markets the rate increase it was anticipating in March, and another rate increase is expected on June 13, the next Fed meeting that includes a press conference, economic projections and a rate-signaling dot plot. This will be about the same time that the inflation data should show some firming, so it will be interesting to see if the narrative changes, and the Fed gets more aggressive on rate hikes. But the rate-hike path as currently laid out by policymakers and Fed Chair Jerome Powell—two more this year and three in 2019—would keep the benchmark funds range at a level that historically has been supportive of stocks.

We also will maintain a watchful eye on other areas of concern. Tariffs are taxes that hamper growth and reduce economic efficiencies, so it’s worthwhile to monitor for a potential breakout in tit-for-tat retaliations. Facebook’s troublesome data-sharing policies and President Trump’s attacks on Amazon have taken the shine off the star Tech sector that drove the market’s big up-surge the past year. And the outcome of recent special elections suggest a potential Democratic midterm wave may be building, threatening the Republicans hold on the House. The thing is, there are always worries. But so long as earnings growth remains robust, inflation and interest rates grind higher and the Fed continues to move at a measured pace, we continue to think that the risks are to the upside.