Strong Earnings Growth Faces Off With Rising Interest Rates

Market volatility has persisted as wide intraday swings in stock prices have continued to be the norm following the stock market correction in early February. 

There has been a tug-of-war for the market's attention between higher interest rates and strong earnings growth. On one side the interest rate on a 10-year U.S. Treasury Bond topped 3% this week for the first time since early 2014. Coming into 2018 the 10-year rate was 2.40%. Remember that when interest rates go up that means that bond prices are declining. The Barclays Aggregate Bond Index, which is viewed as the S&P 500 of the bond market, is down 2.67% year-to-date and Long-Term U.S. Treasuries have declined 7.07% year-to-date. It has been several years since we owned Long-Term Treasuries as the risk of interest rates going higher outweighs the reward of earning a slightly higher yield. 

Also taking it on the chin this year:

Consumer Staples      -10.20%

REITS                        -9.02%

Utilities                      -3.05%

What these investments have in common is that all three doubled in price between 2011 and 2016, outperforming the S&P 500 as investors searched for high-paying dividend stocks with bond rates and money market rates extremely low.  

The valuation of these "bond-proxies" are still not cheap and if interest rates continue to go higher there will likely be more pain ahead for this group.

The high yield for the 10-year U.S. Treasury in 2014 was 3.03%. Earlier this week that level was tested again and rates subsequently backed down to under 3%. The issue for some investors isn't necessarily higher interest rates, but the concern is the potential for interest rates to quickly move higher making it more difficult for the market to adjust.  

10 yr us chart.JPG

As we approach the halfway point for first quarter earnings reports, revenue and earnings growth continue to be sensational. Earnings are on pace to grow 21.1% with revenue increasing 7.6%. It was not too long ago that some analysts said that low single digits growth was the best that could be expected and that the days of faster growth across the board were gone. 

As of January 1st, 2018 the projected growth rate for first quarter earnings was 12.2%. Actual results are going to be nearly double those projections. 

A theme from 2011-2016 was that analysts were overly optimistic each year in their forecasts for earnings growth (and economic growth as well) and as the year progressed would have to cut their forecasts. 2017 earnings growth came in slightly below the initial forecast and so far in 2018 analysts have significantly raised their forecasts.

earnings proj.JPG

Let's briefly touch on a few more issues. 

The Cass Freight Index gives valuable insight into the level of economic activity by tracking freight expenditures and freight volumes. This chart does a good job of illustrating the dramatic turnaround that has taken place in the U.S. economy since the beginning of 2017.

This index is a leading indicator of economic activity so the March reading is a positive for future economic growth. 

cass freight.JPG

The U.S. consumer continues to feel very good about the economic outlook. When consumers are more confident in the economy they tend to spend more.

cons conf.JPG

Part of the reason for the consumer's positive outlook is that their take home pay is increasing at the highest rate in over ten years thanks to the recent tax cut. March saw an increase of 7.5%, up from the 2%-3% range previously seen.

bac wage proxy.JPG

As first quarter earnings season continues to unfold we will closely track not only the earnings themselves, but also companies outlook for the rest of 2018. We will also monitor interest rates with particular attention around the 2014 high yield of 3.03%. Keep in mind that strong economic data does not guarantee more upside for the stock market. That said, 20% earnings growth on the back of double-digit earnings growth in 2017 provides a strong foundation for stocks. 

February Jobs Report Blows Past Estimates

Stocks soared last Friday as the February jobs report showed 313,000 new jobs were added in February, blowing past economists projections for 212,000 new jobs. This is an extremely strong showing considering the unemployment rate is already near historical lows at 4.1%. Also, labor force participation grew 0.3% to 63%, its largest one month increase since 1983. Over 800,000 workers came back into the work force. This is a very positive development for the economy and one that should continue. 

Almost 100,000 of the new jobs created were in construction and manufacturing. That continues a revival in those industries that has taken place over the past year.

Another key aspect of the jobs report was the growth in wages of 2.6%. The stock sell-off in February was initiated when the January jobs report was released and showed wage growth of 2.9%. This led investors to become concerned that higher wages would lead to a significant increase in inflation. A significant increase in inflation would lead to a quicker pace of rate increases by the Federal Reserve. The decline in wage growth from 2.9% in January to 2.6% in February should help ease the concerns about inflation.

The Federal Reserve's target inflation rate is 2% for the Personal Consumption Expenditures. Looking at the chart below it is notable that inflation has run well short of the Fed's target over the past 10 years.   

core pce.JPG

Time will tell if investors really need to be concerned about rising inflation. For now the U.S. economy continues to show real strength with low inflation as the latest jobs report and Core PCE report confirms.

Stock Market Decline Jolts Investors

The peace and calm the stock market saw in 2017 has officially come to an end as the Dow Jones Industrial Average fell 1,175 points today. This was a decline of 4.60%. Over the last six trading days the Dow is now down 8.54%.

This has shocked a market that had not experienced a decline of 5% in over two years. 2017 was characterized by extremely low volatility in the stock market. Everyone knew such low volatility could not continue but no one knew when volatility would spike.

Many times during declines like we have seen in the last week, analysts rush to assign blame for the decline. The bottom line is that often times there is no major reason for the decline other than this kind of thing just happens from time to time in the market. 

Tonight some of the top reasons given for the decline are:

1) Fear of interest rates rising too quickly

2) Will rising wages trigger a significant increase in inflation?

3) Did computer/machine trading cause indiscriminate selling?

4) Will the new Fed Chair, Jerome Powell, look to increase the pace of Fed rate hikes from what we have seen from Janet Yellen?

In October of 1987 the Dow fell 508 points, which was 22.6%. That was a much more significant decline than what we experienced today and many investors still don't know the reason that decline was so steep. 

It is important to keep in mind that this decline has returned the market to levels last seen in mid-December, or less than two months ago. The positive data that drove the market higher in 2017 and early 2018 are still in place. Namely, strong earnings growth, improving economic growth both in the U.S. and abroad, interest rates that are still low on a historical basis and the tax bill that has already greatly benefited companies and workers. 

That being said, stock market declines and market volatility are still unpleasant. Obviously, no one has a crystal ball, so we will continue to closely monitor your portfolio and make any necessary adjustments should they be needed. 

One last thing, do not be surprised if tomorrow morning (Tuesday) stocks open down an additional 2%-3%. If that occurs we would then see if traders become buyers and restore some calm to this frazzled market.

U.S. Economy Continues To Gain Steam

As 2017 winds down recent economic developments have heated up. Let's dive in.

Tax Bill

Only time will tell what the ultimate impact of the tax bill will be. There is little doubt however that the reduction in the corporate tax rate from 35% to 21% will be beneficial. At 35% the U.S. had the highest corporate rate in the developed world. The 21% rate will make U.S. companies much more competitive on a global scale. A recent trend was for companies to move their headquarters out of the U.S. to countries with lower tax rates. With the new 21% rate there should be a dramatic reduction in these corporate inversions. 

Another very positive change was reducing what has been called the repatriation tax. Under existing law companies have paid the 35% tax rate on profits they had made overseas that they brought back to the U.S. This tax was in addition to companies paying taxes to the country in which the profits were earned. The tax bill reduces this rate to 15.5% and going forward the U.S. will not tax foreign profits brought back home. Estimates are that there is anywhere from $3 trillion - $5 trillion in cash that could be brought back into the U.S. by this change.

The ink is not even dry on the tax bill and we are already seeing companies reacting positively to the passing of the bill:

AT&T has announced that due to the tax bill passing Congress they are giving 200,000 employees an immediate $1,000 bonus and they will be spending an extra $1 billion in capital expenditures. 

FedEx's Chairman Frederick Smith said that the tax bill will prompt the company to increase hiring as well as new business spending as the tax cut will give them an extra $1.3 billion in profits. 

Fifth Third Bank announced that with the passing of the tax bill they will be raising minimum wage at the bank to $15/hour and will be giving over 13,000 employees a $1,000 bonus.

Economic Growth

The New York Fed just raised their 4th Quarter GDP estimate to 4%. This is coming on the back of 3Q GDP rising at the fastest level in 3 years. A narrative by some economic analysts in 2016 was that the U.S. economy had entered a new normal where GDP growth couldn't exceed 1.5%-2%. We have seen this year that pro business policies have buried that narrative. We expect GDP growth to continue above 3% in 2018.

Consumer Confidence

Since the election in 2016 a common theme has been a major increase in confidence in the economy both by consumers and businesses. 

U.S. Consumer Confidence just hit a 17-year high in November as U.S. consumers are more and more confident in the economy and the jobs market. This increased confidence has led to a major increase in U.S. retail sales. Holiday spending is off to a fantastic start. 

Retail sales.JPG

It isn't just the U.S. consumer whose confidence is soaring:

The NFIB's Small Business Optimism Index hit a 34-year high in November. Small business owners are the top job creators in the U.S. so this is a very positive development.

U.S. Homebuilder confidence hit the highest level since 1999. New home sales also recently hit their highest level since 2007.

Earnings

The final number for 2017 earnings growth will not be known until 4th Quarter numbers are reported by companies in January and February, but based on real numbers in 1Q, 2Q, 3Q as well as 4Q estimates, 2017 earnings growth for the S&P 500 will be close to 12%. 

Earnings growth has been a significant driver of U.S. stocks in 2017. The earnings outlook for 2018 is also very strong and with the passage of the tax bill some analysts are expecting 13%-15% earnings growth.

The U.S. economy has heated up in 2017 with consumer and business confidence soaring and strong corporate earnings growth exceeding expectations. The passage of the tax bill will mean lower tax rates for many U.S. companies which will lead to higher earnings in 2018. However, one factor that will be critical to market returns in 2018 will be the movement in interest rates. We will address this issue and more in an upcoming post. Merry Christmas.

Social Security Checks Rising in 2018

The Social Security Administration has announced that recipients will be receiving an increase of 2% in 2018. This is an announcement that will be welcomed by retirees who saw only a .3% increase in 2017 and no increase in 2016. 

Unfortunately many recipients of Social Security who are also on Medicare will find that the Social Security increase is eaten up by higher premiums for Medicare Part B. 

Since 2000 the average Social Security increase has been 2.2%. 

The Wall Street Journal has more.
 

China Update

Over the past decade cash from China has been deployed into assets such as stock, bonds and real estate around the globe. The Chinese government, concerned by the level of cash leaving the country, has put capital controls into place to slow this flow of cash leaving the country.

From the Wall Street Journal:

China’s seemingly insatiable demand for foreign assets has driven up prices for everything from U.S. Treasury bonds to global companies to luxury real estate. Now, a combination of market forces and capital controls are choking off the flow of Chinese cash. Asset markets around the world will have to adjust.

As Chinese exports boomed starting in the early 2000s and foreign investment flooded into the country, the central bank recycled these inflows into foreign government bonds, mostly Treasurys, to keep the yuan from rising. The buying persisted for over a decade, driving bond prices up and driving yields down globally.

Earnings Heat Up

As we head into the back half of summer, company earnings are heating up while market volatility has declined to an all-time low. We also have an update from the continued fallout in retail after Amazon's purchase of Whole Foods. Let's dive in.

Earnings

An important issue for the market coming into 2017 was the quest for a return to strong growth in company earnings. After 5 quarters of flat or negative earnings growth, the 1st quarter of 2017 saw growth of 14%, a blockbuster number. The next question was whether the 1st quarter number was a fluke or if the strong growth would continue?

With over half the companies in the S&P 500 reporting 2nd quarter numbers, profits are on pace to grow by 11%. It is this growth that has helped to power the stock market to record highs. 72% of companies in the S&P 500 have beaten their earnings estimates compared to the long-term average of 64%. 

Another piece of good news is that revenue growth is up 5% for these companies with 69% beating expectations vs a long-term average of 59%. 

As long as healthy earnings growth continues, the path of least resistance for the market is higher.

Volatility

One of the most important measures of market volatility, the CBOE Volatility Index(VIX), hit an all-time low within the last week. The VIX tends to spike higher when stocks sell-off or when market participants are fearful. With the VIX at record lows there is a debate about whether investors have become too complacent. However, according to Bank America investment managers are holding above-average levels of cash in their portfolios. Also, there is a high level of "short interest" in stocks, that is betting that stocks decline in value. These are not signs of a market with excessive optimism. Typically when the market is close to a near-term top investment managers have very little in cash and short interest is low.  

sc.png

Amazon Impact

Since Amazon's announced purchase of Whole Foods on June 16th, many companies from all walks of retail have seen their stocks sell-off. 

Here is a look at how far some strong companies have fallen from their 52 week highs in large part due to concerns of competition with Amazon:

Costco -17%

Kroger -31%

Auto Zone -30%

Ulta Beauty -20%

Target -27%

There is no question that Amazon has disrupted the business model of many retailers. Many department stores as well as specialty retailers have gone up in flames as they were unable to adjust to Amazon.

That said, there is a limit to how many business segments Amazon can dominate before the government becomes concerned with a monopoly status. We aren't there yet, but as the retail shakeout continues there will be some buying opportunities in the space as the baby gets thrown out with the bathwater.   

With the majority of companies in the S&P 500 having reported 2nd quarter earnings, the results have been very good, extending the earnings recovery that began in the 1st quarter. The market response to earnings has been to move higher with low volatility. Whether investors have become too complacent or not will become clearer as we head into the fall. While there will still be values to be found, whether related to the Amazon impact or not, we will continue to closely monitor your portfolios. 

Amazon Upends Grocery Industry

This morning news broke that Amazon.com is buying Whole Foods Market for $13.7 billion. This move will give Amazon a foothold into the brick-and-mortar side of retail that Amazon has significantly altered. The potential impact of this deal could be as large as anything we have seen in decades.

Investors voiced their approval of the deal sending Amazon's stock up 2.44%. Often the acquiring company's stock declines upon deal announcements. However, in this case investors, at least initially, are excited about the opportunity ahead for Amazon given the fact that the size of the grocery market is $800 billion per year. 

Kroger, Target, Walmart and Costco were all among the companies that had significant sell-offs on the news. There is a question about whether the depth of the sell-offs were overdone. The grocery industry typically has slim profit margins, and with Amazon now taking aim at the industry competitors are going to have to figure out how to innovate if they don't want to lose market share to Amazon. 

Currently online sales makes up only 2%-3% of the grocery business. That has always been expected to increase but with Amazon now in the business that should accelerate this shift. 

In other news, the U.S. dollar has declined 6.5% from the five-year high it set last December. 

 Source: Bloomberg

Source: Bloomberg

The dollar's decline has been beneficial to many of the large U.S. firms that get a majority of their sales from overseas. When the dollar is too strong it leads to lower earnings by the multi-nationals. Other benefactors of a weaker dollar are emerging market economies. Many borrowers in these countries accumulate dollar-denominated debt which becomes cheaper to repay when the dollar weakens vs the particular emerging market currency. 

As long as the dollar doesn't make a strong move in either direction from current levels it shouldn't have a significant impact on the economy.

The recent decline of the dollar has benefited large U.S. multi-nationals and the dollar will continue to be carefully watched. Also, Amazon's purchase of Whole Foods will have a ripple effect across multiple sectors and will offer some investment opportunities. I believe this story will continue to be the focus of the financial media until second quarter earnings reports begin in July.

 

 

Earnings Reports Send Stocks Higher

As the summer approaches the stock market is near it's high powered by strong earnings reports and increased business confidence that has led to higher business spending. Let's dive in.

Earnings Reports

Analysts' earnings expectations for the S&P 500 have consistently been too optimistic during this economic recovery. In fact, going back to 2012 every year has seen earnings come in at less than half of initial forecasts. If this pattern can be reversed we could see added fuel for the stock market in the coming years.

 Source: Bloomberg.com

Source: Bloomberg.com

With close to 70% of companies in the S&P 500 having reported their first quarter numbers, we have seen earnings growth in excess of 10% compared to the first quarter of 2016. That reverses a trend over the previous eight quarters of earnings declining on average. While this is a great start to 2017, there obviously is a long way to go for this to become a trend. 

Small Business Update

Small businesses make up 64% of net new private-sector jobs in the United States. So it is good news that small business owners are the most optimistic they have been in the last thirty years about the economic outlook. The results of the presidential election contributed to this as business owners are hopeful for tax reform, regulatory reform, infrastructure spending and a new health care plan that will reverse two decades of policy mistakes by both parties. Of course no one knows what exactly will get passed and become law, but optimism for pro-growth polices appear to already have changed behavior as business capital spending jumped 10% in the first quarter compared to the first quarter of 2016. Capital spending includes expenditures on items like property, plant and equipment. Since the 2008 crisis, many businesses have been very hesitant to increase capital spending and that has been one of the big reasons economic growth (as measured by GDP) has been so sluggish during the recovery. 

 Source: NFIB.com

Source: NFIB.com

The Federal Reserve

The Federal Reserve is expected to raise interest rates when they meet again in June. This would be their second increase of 2017 and third increase since last December. We have felt for a long time that the Fed should have been raising rates twice a year going back to 2013. 0% interest rates made sense during the financial crisis, but were kept too low for too long. If the Fed does raise rates in June it would set the table for a third increase during the second half of the year. It will be important for the Fed to not push for a fourth increase in 2017 as the cumulative effect of five increases in thirteen months could have negative ramifications for the economy here and around the globe. 

Second quarter earnings reports, small business behavior and the Fed's June decision will give us more information about what the economy and the markets will have in store in the second half of 2017. In addition to these issues there are always developments in China that will have an investment impact, and we will have see what kind of  progress is made in Washington regarding everything from tax reform to infrastructure. 

 

Optimism Sends Markets Higher

Animal spirits have returned to the markets, at least temporarily, as there have been major shifts since the U.S. presidential election. While there is still not a lot of clarity on the details of President-elect Trump's policies, expectations are that much needed tax-reform, a reduction in excessive regulations and new infrastructure spending will give economic growth a shot in the arm.

Stocks and Bonds

U.S. stocks have rallied, led by small-caps, financials and industrials all gaining over 10%. 

Bond prices have plummeted sending interest rates swiftly higher, with the yield on the 10-year U.S. Treasury rising from 1.74% before the election to 2.49% today.  

Many financial pundits have been predicting a rise in interest rates every year for the past five or six years. Up until now that has not been the case with interest rates hitting an all time low this summer.

As a result of low rates, stocks like consumer staples, utilities, telecoms, as well as corporate bonds and government bonds have outperformed since 2010 as investors chased higher dividends and interest income. Short-term rate increases in interest rates during this time provided buying opportunities for these investments. Since the election these investments have been sold off by the market and if interest rates continue higher the low-rate/low-growth playbook that was so profitable for so many years could continue to be under pressure.

Oil

Oil has surged to $51/barrel aided by OPEC members agreeing to to cut oil production for the first time since 2008. U.S. oil hit a low of $26/barrel in February 2016 before rallying. Since March, oil has traded in a range between $43 - $52

While the OPEC agreement is a good sign for oil prices going forward, there are doubts about whether the countries involved will stick to the agreement. Also, with the recovery in oil prices U.S. production is expected to pick up, offsetting some of OPEC's cuts. Many analysts believe a range of $50 - $60 would be beneficial for the U.S. economy moving forward.

Economic Surveys

The NFIB, which surveys small businesses on a monthly basis, reported in November that small businesses are the most optimistic about their new hiring plans than they have been in over ten years.
From the Wall Street Journal:

The National Federation of Independent Business monthly employment survey for November will show that owners of small firms are preparing for a better future. “A seasonally adjusted net 15 percent plan to create new jobs, up 5 points from October and the strongest reading in the recovery,” NFIB Chief Economist William Dunkelberg tells us.

Consumer confidence reached a nine-year high in November with The Conference Board's measure jumping to 107.1, up from 100.8 in October, far outpacing economists expectations of 101.8. Consumers tend to spend more when they are upbeat so this report is positive for holiday retail sales.

It remains to be seen how markets will perform moving forward. In December the Federal Reserve will meet and are expected to raise interest rates a quarter point. What the Fed says about their plans for 2017 will be closely watched. Coming up December 4th Italy is holding a referendum, which if voted down will lead to the resignation of their Prime Minister. Following in the footsteps of Brexit and the U.S. Presidential Election, we expect the No vote to win.
It is expected if No wins there could be a vote in Italy next year to determine if Italy will leave the Eurozone. 

We are in the process of making necessary adjustments to our portfolios and will continue to track all developments both here in the U.S. and abroad.