Orlando's Outlook: With worry comes opportunity

06-05-2018

Bottom Line The S&P 500 has rallied nearly 8% over the past two months, fueled by a stellar first-quarter corporate reporting season, in which earnings per share soared about 25% year-over-year (y/y), with three-quarters of the companies beating consensus expectations more than 7%. That marks the fourth consecutive quarter with double-digit earnings growth—the strongest such period since 2011—in sharp contrast to the earnings recession that lasted for seven quarters through mid-2016.

But with those favorable revenue and earnings reports, and positive corporate guidance now largely behind us, we’re entering an earnings vacuum for the next six weeks or so. Companies won’t start to report their second-quarter results until mid-July. We expect second-quarter earnings will be pretty robust, too, perhaps up some 20% y/y.

The tone and tenor of this information wasteland over the next six weeks may well be pocked with a variety of geopolitical risks, including Italy’s political instability, nuclear concerns surrounding North Korea and Iran, and fears of Trump-inspired trade wars.

Have markets already discounted these near-term risks and are looking through the haze to a strong fourth-quarter rally? Or could we experience a temporary 5% air pocket at some point over the summer, which would provide investors with an attractive buying opportunity?

Wall of worry While investors have worked themselves into a tizzy climbing this impressively constructed international wall of worry, their concerns also include some domestic issues, including an increase in the pace of Fed rate hikes and a spike in inflation. For now, however, neither appears imminent. The Federal Reserve’s leadership and policy transition is progressing smoothly, and we expect another quarter-point rate hike on June 13, with at least a third hike to follow later this year. And inflation seems to be more of a gradual grind higher, with core PCE up 1.8% in each of the past two months (still below the Fed’s oft-stated 2% target).

Third, the yield curve is clearly flattening but has not inverted, and we do not see any signs of recession on the horizon for at least two more years. Finally, the so-called Democratic blue wave looks less likely to swamp the contentious midterm elections in November. Trump’s poll numbers are rising and generic ballots for Republicans are improving, thanks to a solid labor market, strong economic and corporate-profit growth, and rising equity prices.

Economic growth accelerating To that last point, consumer confidence metrics are near multi-decade cycle highs, the labor market rebounded in May, and consumer spending and retail sales have shaken off their winter doldrums, sparking their best “Mapril” results in six years. Manufacturing has strengthened, as the national ISM index surprisingly leapt in May along with six of the Fed’s regional indexes, and capacity utilization hit a new 3-year high in April. Finally, net trade improved 15% in March to a $49 billion deficit from February’s $57.7 billion deficit, its worst level in nearly a decade.

Air pocket could be a buying opportunity All told, the market’s powerful economic and corporate-earnings fundamentals paint a bullish picture to support our thesis for a year-end rally to 3,100 on the S&P. We would treat any modest summer stumbles related to the aforementioned wall of worry as an attractive buying opportunity.

Adjustments to our GDP forecasts The equity and fixed-income investment professionals who comprise Federated’s macroeconomic policy committee met last Thursday to discuss the mix between geopolitical risk and the strengthening domestic economy.

  • The Commerce Department flashed first-quarter 2018 GDP at a gain of 2.3%, which it subsequently revised down to 2.2% last week. The final revision will come June 28. Given the sequentially revised improvement in both net trade and consumer spending in March, first-quarter GDP may rise a tick.
  • Due to more seasonal weather, the late tax refunds and the recent improvement in both net trade and consumer spending in April, we’re continuing to expect some snapback in the second quarter. As a result, we are increasing our second-quarter 2018 GDP estimate by a tick, from 3.4% to 3.5%, while the Blue Chip consensus is raising its estimate from 3.1% to 3.2% (within a wide range of 2.6% to 3.9%). In fact, the Atlanta Fed’s widely followed GDPNow model raised its estimate to 4.8% from 4% a fortnight ago. Second-quarter GDP will be flashed July 27.
  • We are keeping our third-quarter 2018 GDP estimate unchanged at 3.1%, while the Blue Chip consensus remains unchanged at 3% (within a range of 2.5% to 3.5%).
  • We also are keeping our fourth-quarter 2018 GDP estimate unchanged at 2.9%, while the Blue Chip consensus similarly remains unchanged at 2.8% (within a range of 2.4% to 3.3%).
  • Because of Commerce’s first-quarter downward revision, we are lowering our full-year 2018 GDP estimate down a tick, from 3% to 2.9%, while Blue Chip consensus remains unchanged at 2.8% (within a tight range of 2.7% to 3%).
  • Our full-year 2019 GDP estimate remains unchanged at 3%, while the Blue Chip consensus remains unchanged at 2.6% (within a range of 2.1% to 3%).

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