Corporate Earnings Face Off Against Shifting Rate Environment – Week Ended 4/27/18

The final full week of April might best be described as a tug of war between big macro concerns and favorable micro inputs. All of which combined such that the domestic stock market was unable to find direction throughout the week and concluded virtually unchanged over the 5 trading days ending April 27 (as measured by the S&P500 and broad Wilshire 5000). By contrast, reference-rate bonds on the other hand experienced a noteworthy development wherein the 10-year US Treasury climbed above 3% for the first time in more than 4 years (it closed the week just under at 2.96%) and the Fed is signaling no intention of slowing their hikes. As recent as year-end the same bond maturity sported a stubbornly low yield of just 2.4%; so the roughly +60 basis point rise represents a +25% adjustment in just 4 brief months. With the US Federal reserve and other major monetary authorities around the globe continuing to communicate a preference toward further normalization, including through rate hikes, rates seem poised to rise further.

From a fundamental perspective, the weekly flow of economic data remains generally supportive. Weekly jobless claims fell again and the labor market appears quite healthy. While positive, this data series continues to fuel concerns that inflation via wage growth simply must pickup and there is evidence supporting this. The ECB was also mildly dovish on interest rates. The big story in recent weeks however is how strong is 1Q earnings season so far. With roughly a third of the S&P reporting, 78% are beating on earnings and 68% are beating revenue projections as well. If continuing at this pace, the overall level of S&P earnings for 1Q stands to be up between 15-20% over the same period a year ago. It is true that some of this is related to tax-cut related gains, but these are still real profits that can be utilized by corporations to invest in future productivity (or less desirable stock repurchase programs). Also recent earnings inputs are so robust it would seem impossible to last at this pace for long. In that vein, several companies are choosing to try and rein in investor expectations and avoid setting expectations too high. Fundamental data is not without its misses either however; recent data out of Europe is at times recently appearing toppy and China is witnessing slowdown. Global industrial share prices are weakening on a relative basis, which probably has at least as much to do with sharp tariff talk as it does with any actual change in demand as recent commodity price gains suggest economic activity is doing anything but tapering off at present.

At present, the wall of worry for the market remains substantial. Interest rates are continuing to rise, the yield curve is flattening, trade wars and tariff deadlines are looming, and domestic political uncertainty seems likely to increase as we move toward mid-term elections later this year. All these come at the same time as pessimists posit that we are witnessing peak corporate profit growth and the 2018 personal income tax cut is being saved by consumers rather than utilized to consume (so viewing current positives as future negatives). While for the moment it appears the stock market cannot find direction, we continue to believe there is still momentum in this business cycle. We would view that investor sentiment deteriorating and well off what was often argued as complacent is a positive. Further while monetary policy is certainly tightening in pursuit of policy normalization, history reveals that interest rate increases are actually a positive for stock prices when the US 10-year is below 5%. In other words, rate increases early in the hiking cycle were generally the result of improving economic expectations and still heathy inflation; further, monetary policy normalization has a good distance to go before it could be considered in any way too tight.

Posted in Blog Post.