Robust Earnings More Than Just a Tax Cut Story – Week Ended 5/11/18

US equities rebounded in the second week of May, with the broad S&P500 climbing by +2.4% and more cyclically sensitive areas of the market faring even better (Dow Transports +3.3%; Small-Caps +2.9% at the expense of defensive industries like Utilities -2.1%). The strong weekly performance was likely the combined result of unfaltering strength in 1Q earnings season (nearing a conclusion), softer than expected readings on inflation, and tough trade & tariff talk that seems to be thawing (obviously the situation is fluid and could reverse again quickly). On the geopolitical front, the US also recorded a win from N. Korea with the announced release and return of 3 prisoners back to home in the US.

From an economics perspective, the most encouraging news last week was the message from data revealing that inflation, while up, does not appear to be running away. Consumer and business sentiment also remains elevated. Spring housing season looks set to be in respectable shape as well despite notably higher borrowing costs vs. a year ago as applications for home purchase are not as soft as feared. Too, with more than 90% of S&P500 constituents reporting, approximately 75% have beaten both earnings and revenue estimates. Better than expected revenues suggest that it is not just a one-time accounting windfall from recent tax cuts propelling 1Q results. It also stands to reason that corporate plans for cash will develop beyond share repurchases which received significant media attention last week (share repurchases return cash to shareholders and generally offer short-run support for equity prices). Investments of capital if made, rather than returned to investors, become another companys revenues. Beyond data however, one could ask most anyone on Main Street their take on the economy and it seems likely they would perceive the economic world around them as appearing quite strong. This is important because in an economy as large as the US, trends do not turn on a dime.

Despite an economic backdrop that would still appear favorable, domestic and international equity markets remain choppy to-date and the wall of worry for the market is substantial. The noteworthy concern from a month back as to whether we are experiencing peak earnings growth seems to have morphed into a more troubling fear of peak earnings PERIOD. Additionally, recent US$ strength and rising bond yields are creating financial stress for emerging markets while at the same time international growth is appearing toppy recently. Closely watched too is the slope of the yield curve, which continues to flatten and appear on a path toward inversion. Yet while an inverted yield curve has the strongest historical correlation to economic recession of almost any indicator, inversion typically occurred between 12 and 18 months on average before an economic recession. It is in that vein that all things considered, there is still some runway left for this economic cycle. And, in the short-run it feels at least as if the number of negative headlines about trade and geopolitical tensions might be softening. Still, we are careful to note that financial markets do not always mirror the economy and for now at least it would seem as though the US economy is in a strong position to outperform the stock market in 2018 even if the worst of the market correction that began in late-January might be behind us.

Posted in Blog Post.