Earnings Season
As we mentioned in our recent quarterly newsletter, we believe there is a low probability of recession as we head into 2017 due to the strengthening labor market, and more specifically, increasing wages. This is important as increasing wages are supportive of consumer spending, which accounts for almost 70% of U.S. GDP. However, we are concerned about the trend of weaker earnings for U.S. companies as we head towards end of the year. Declining oil prices and a stronger U.S. dollar experienced in 2015 and earlier this year resulted in five consecutive quarters of weakening earnings. Although these headwinds have subsided, if earnings continue to trend lower this may cause us to change our near-term outlook. Earnings are an important driver of stock market returns, especially as the Federal Reserve moves from an accommodative monetary policy to a tightening policy (i.e. raising interest rates). Recent commentary from the Fed suggest a potential rate hike in December, and the market has priced in over a 60% probability of this happening. With year-end rapidly approaching, where do earnings stand today and is the economy strong enough to withstand higher interest rates?
Of the 500 companies in the S&P 500 Index, 116 companies have reported earnings so far for the Third Quarter, with over 80% beating their estimates. This is a positive sign, along with profits being nearly 7% higher than initially expected. If this trend continues, it should be enough to break the five consecutive quarters of declining earnings. Beyond earnings, recent economic data has shown the economy to be on pace for 2-3% GDP growth for the second half of 2016. Retail sales rose 0.6% in September and are up almost 3% versus a year ago. Industrial production, after being down for much of the summer, rose in September. Housing data was mixed for the month, as housing starts (a measure of new construction) fell well short of consensus estimates, while existing home sales rose 3.2%. We are less concerned by the decline in starts, as much of this was due to a decline in multi-family (apartment) construction, while construction on single-family homes rose 8% for the month. We are starting to see more and more first time home buyers entering the market, which is encouraging as they are being helped by still historically low mortgage rates and a strong labor market. More importantly, the Consumer Price Index (CPI) rose 0.3% in September, and is now up 1.5% from a year ago, as inflation is inching closer to the Fed’s 2% target.
If earnings continue to surprise to the upside, and economic data along with inflation continue to strengthen, then it is likely that the Federal Reserve will raise interest rates this year. However, this may create some uncertainty as traders assess the potential for a rate hike, which could result in periods of market volatility especially coupled with the upcoming presidential election. Although we view this as a positive scenario for the equity market over the long term, we have maintained higher than normal cash balances in client portfolios given the level of uncertainty. We will continue to monitor the current environment and deploy cash as we see opportunities to invest at more attractive levels.