During a quarter in which political turmoil was a dominant theme, investors in the U.S. equity market largely shrugged off headlines and media noise. Other than two brief downturns in mid-April and mid-May, equities advanced with relatively little volatility. However, increased focus on political controversy stalled pro-growth initiatives, and investors became considerably more skeptical about the administration's ability to make progress in areas such as deregulation, infrastructure spending, and corporate tax reform.
Slow and steady may be the best paceHeightened uncertainty in Washington remains a key risk for equities as we enter the second half of 2017. In our view, however, a number of favorable trends remain in place and are likely to keep politics from derailing market momentum. Corporate earnings strength may be the most potent positive force. Investors have shown an impressive ability to look beyond headline distractions and focus on healthy fundamentals and the stronger-than-expected financial results we've seen from many U.S. businesses.
Investors have shown an impressive ability to look beyond headline distractions and focus on healthy fundamentals.
We are in unprecedented territory as the Fed works to reduce a balance sheet that has grown to more than $4 trillion.
Corporate earnings performance has been moderately better than expected, with a return to growth, on a year-over-year basis, in the first quarter of 2017. Second-quarter growth is expected to be solid, and corporations continue to be reasonably conservative with their free cash flow. Also boosting prospects for earnings is the belief that corporate tax reform is one victory that could emerge from the Trump administration agenda.
Despite a backdrop of political drama, many areas of the economy have been quite uneventful — a scenario that we believe could continue to fuel the market in the months ahead. Along with a slow and steady advance for equities, we have seen moderate improvements in wage growth, employment, consumer confidence, and consumer spending. While moderate changes may not generate headlines, they tend to bode well for stock market performance and investor sentiment.
Sectors to watch in the wake of large-cap growth dominanceAs prospects for growth stimulus dimmed in the second quarter, investors again began to focus on a narrow band of large-cap growth stocks, particularly in the technology sector. Other notable areas of growth outperformance have been the health-care and consumer discretionary sectors. Large-cap technology stocks, and the growth stock universe as a whole, have outperformed value stocks — especially in financials, energy, and consumer staples — by a considerable margin. Despite a still uncertain macroeconomic picture, we are focused on opportunities in value stocks, given their underperformance and more reasonable valuations relative to growth stocks.
While moderate improvements may not generate headlines, they tend to bode well for stock market performance and investor sentiment.
The financials sector is one area where we see potential for the remainder of 2017. The sector struggled a bit in the second quarter due to declining enthusiasm about legislative success in Washington as well as stubbornly low long-term interest rates. We believe, however, that continued tightening in the labor market and rising wages could lead to higher inflation and interest rates, which would be beneficial for businesses in the financials sector. Additional support could come in the form of progress on the deregulation front — an area of the Trump agenda that may not involve overly complex Congressional battles.
The risk of uncertainty: Fed's next steps, political distractionsAnother calming influence on the equity market has been a deliberate, communicative, and fairly predictable Federal Reserve. However, we see potential risks for equities in the context of Fed policy. While its three interest-rate hikes since December were widely expected, much less certain is the effect on markets when the Fed begins the process of shrinking its balance sheet. Investors have become quite accustomed to the Fed's accommodation, and we are in unprecedented territory as the Fed works to reduce a balance sheet that has grown to more than $4 trillion — the result of its purchases of Treasuries and mortgage-backed securities to help stimulate economic growth.
Equity markets don't typically respond well to uncertainty, and at the mid-point of 2017, we have plenty to consider. In addition to the Fed's next steps, many wonder what's next for a presidential administration that is notorious for its unpredictability. It is likely that the market's resilience will continue to be tested by investigations and potential scandals, as well as global geopolitical concerns.
More from Equity Outlook
For U.S. equity investors, the second quarter offered a number of familiar themes: relatively low volatility, new record highs for major indexes, and a modest advance for stocks.