The Plot Thickens: More Than Meets the Eye
As we reflect on the last eight years, various stages of the economic and market recovery have unfolded like chapters in a book. Many parts have told a predictable tale and, at various times, we have been left wondering if there would be an unpredictable twist or a surprise ending. While the story may be growing old, with the same account of slow economic growth and low interest rates being told year after year, we feel positive change may be afoot as the global economic picture brightens.
The story began eight years ago in March of 2009 when the U.S. stock market bottomed during the Great Recession and thus began a healthy ascent, with the S&P 500 reaching a new all-time high by 2012. Market returns during this time were driven by an earnings recovery across all sectors of the economy and, low and behold, the “new normal” ended up being the “old normal.” Fears of a double-dip recession turned out to be overblown but many investors’ wounds were still healing and some hadn’t yet been convinced that danger wasn’t lurking just around the corner. A “Flash Crash” in 2010 and a U.S. Treasury market downgrade in 2011 added to their anxiety, leaving them shaken. As a result, valuation levels of the market remained very low relative to historical averages.
In 2013, the plot thickened and changed significantly following the Federal Reserve’s decision to taper their stimulative bond buying, known as Quantitative Easing. This led to a sharp move in interest rates over the summer months, appropriately named the “taper tantrum.” As many investors fretted over the ability of the U.S. economy to thrive without as much support from the Federal Reserve, we saw economic data continue to improve and many equity investors took notice. Equity markets staged a powerful rally in 2013 that was almost entirely driven by a valuation adjustment back to historical averages.
Over the next several years, earnings growth was almost nonexistent and market volatility picked up significantly as commodity prices experienced one of their biggest downturns in history. Meanwhile, Chinese currency fluctuations rattled markets and fears of a European Union breakdown were brought to bear with a potential “Grexit” and an actual “Brexit.” Despite all this turmoil, domestic equity markets persevered and continued to move modestly higher. Valuation was now moving beyond historical averages, leaving many to ponder what would happen next.
The U.S. Presidential election added another twist to the story as markets moved higher in what many termed the “Trump Rally.” An optimistic view that President Trump’s pro-growth policy would add new vigor to corporate earnings and economic growth contributed to the enthusiasm. Historically, this has been a recurring theme in election years as a political honeymoon period brings hope and anticipation of potential positive changes to come. More than likely, this market rally would have taken place no matter who won the election; however, political headlines have masked an encouraging trend that began in October of last year and has continued into 2017.
Global economic growth and inflation have begun to firm around the world for the first time since the financial crisis as central bank stimulus is finally beginning to bear fruit and a recovery in commodity prices is helping lift many emerging market countries out of recession. This development may serve to prolong the current market cycle and is certainly an unexpected, but not unwelcome, development at this late stage in the story. Per BCA Research, the sum of the Citi Global Economic and Inflation Surprise Indexes is at its highest level in the 14-year history of the survey. This is happening despite geopolitical pressures being felt around the world. While many may fear a “Trump Slump,” we would argue that the rally so far hasn’t been rooted entirely in politics, and politics alone as not sufficient to sustain it.
The rate of corporate earnings growth is also poised to improve to its highest level since the financial crisis, not only here in the U.S., but also in Europe and emerging market countries. The fourth quarter of last year marked a turning point as earnings growth stabilized in the U.S. following five quarters of contraction. Europe experienced a similar turn but it followed a grueling fourteen quarter earnings decline. A handful of sectors - energy, materials and financials - were primarily responsible for the global earnings pain and, in turn, they are expected to contribute significantly to earnings gains over the next twelve to eighteen months as oil and commodity prices stabilize and interest rates rise. Corporate earnings in the U.S. could also be augmented by policy changes impacting taxes, regulation and fiscal spending; however, these changes are not necessary to drive an impressive earnings growth year in 2017.
Like a fairy tale, economic cycles usually end with an important life lesson. In economics, the lesson is almost always the same – greed and excess risk-taking eventually result in a structural breakdown that negatively impacts economic growth. We consider ourselves to be well read in market lore and don’t see excesses building up yet in housing, lending or business investment. Some degree of market consolidation is expected as the story continues to unfold and the market digests its recent move. While it is impossible to predict exactly what will happen next, the economic future is continuing to look bright.
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