A Peek into 2017
Where stocks end the year is anyone’s guess, but peeking into 2017 should reignite optimism. Since July, stocks have been in a narrow range that is getting more narrow as next week’s election approaches. The campaigns of both candidates have been a race to the bottom. Given the choice, American voters would rather choose between Mike Pence and Tim Kaine rather than Mr. Trump and Mrs. Clinton. Perhaps the best outcome is continued gridlock, which seems a certainty if Wall Street’s choice, Mrs. Clinton, does not sweep. Markets can live with a 2% economy, a Fed policy of slowly raising rates, moderate inflation, and increasing corporate earnings. Short term things may get ugly as the mood of America is reflected in the election results.
Normally presidential elections do not have a long-term impact on the financial markets, and this time will be no different. Throughout the post-election period politics will be an overly analyzed input to the proverbial “Wall of Worry.” As mentioned often in our Reports, the US is a 2% real growth economy with no catalysts to break above this sluggish level. Earnings season is winding down and the market will turn its attention to the Fed and a December interest rate rise. Recent economic data, on balance, show some upward momentum and Friday’s employment number should be in line with recent reports. The wages and weekly earnings data from the report may prove the determinant for Fed action. Inflationary pressures are beginning to surface and the last thing the Fed wants is to be behind the curve. As mentioned markets, measured by the S&P 500, remain in a tight range (2,193.91 – 2,114.72) since the beginning of the third quarter. As of last Friday, the S&P 500 was only 1.3% above its June 30, 2016 close. Although only down 3.1% from its all-time high on August 16, 2016, only 32.7% of the S&P 500 companies are above their 50-Day moving average.
Going into the third quarter earnings season FactSet estimated S&P 500 earnings to decline 1.3%. As of October 28, FactSet reported its blended earnings (reported plus estimated) growth rate for the S&P 500 is +1.6% with 74% of the 294 companies reporting earnings above the mean estimates. Thomson Reuters also estimated earnings to decline 1.3% prior to the actual reporting. Data from Thomson Reuters and published in Fundamentalis show S&P earnings beginning 3Q2015 through 2017 when quarterly earnings turned negative year-over-year.
The Table shows a return to profitability beginning in 3Q2016, along with the diminished negative impact of the Energy sector. Although not shown on the Table, the estimated level of growth is in part due to weak comparisons but at rates comparable to 2011-2012, years of substantial stock market appreciation. Depending on the level of inflation, with earnings reported in nominal terms, these levels could change meaningfully in either direction.
To successfully reach the current estimated level of earnings growth, the economy must maintain minimal real growth at 2%. No doubt, there are many unanswered political questions but the economic tailwinds are picking up. Looking into next year we see positive growth in personal income and relatively low delinquency rates supporting consumer fundamentals. Stronger than anticipated payroll growth suggests solid consumer spending. As expected, the tighter labor market has resulted in a slowdown in employment from an average monthly rare of 251,000 in 2014 to 229,000 in 2015 and to 178,000 through September 2016. Accompanying this tightening labor pool has been a recent increase in average hourly earnings, from 2.4% in August to 2.6% in September. Personal income rose 0.3% in September after falling 0.2% in August. Consumer spending rose 0.5% in September, after declining 0.1% in August.
Consumer sentiment appears to be influenced by the uncertainty of the upcoming election and the added problems of the “de facto” bankruptcy of Obamacare. This is reflected in the 5.7% elevated personal savings rate in August. Home prices rose 5.1% in July, positively affecting household net worth. The tight supply of homes is expected to continue but price increases are forecast to moderate. This scenario has been in place for some time as supply has been limited by the lack of new starts of moderately priced homes. Sales of new single family homes rose to 563,000 in September, a 30% increase over year ago levels, but only 3.1% above a downward revised August 2016. Home inventory remains at an historically low 4.8 months. Real consumer spending ex-autos rose 2.7% in September 2016, up from 2.1% in August, and up 2.4% from a year ago September. Leading the sales were non-store retailers (90% online), up 10.6%, once again coming at the expense of Department Stores which were off another 4.8%.
Our investment policy remains optimistic. Rising volatility related to the outcome of the election and the potential Fed policy may continue in the short term. This should not interfere with long-term investment strategy. The recent economic data confirms that we remain in a 2% growth cycle, but with better earnings on the horizon and a healthy and vibrant consumer. The transition into a more consumeroriented economy is on schedule, but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.