Volatility was low and sentiment was high in 2017's first quarter as expectations for a new pro-growth presidential agenda remained intact. Investor enthusiasm over the so-called "Trump trade" only started to waver toward the close of the period, when stocks sold off a bit in the aftermath of the administration's failure to repeal the Affordable Care Act.
Looking ahead, we anticipate an environment in which politics may be the most significant force that drives — or disrupts — U.S. equity market momentum. The first quarter's relatively brief downturn could be an indication of the biggest risk for U.S. equities — that investors will become discouraged by setbacks and a lack of concrete, measurable progress for President Trump's agenda.
We anticipate an environment in which politics may be the most significant force that drives — or disrupts — U.S. equity market momentum.
Will earnings grow if legislation stalls?Despite political uncertainties, we see reasons for optimism, including improving fundamentals for U.S. businesses. Earnings growth has been positive, and we expect it will continue, particularly in light of higher levels of consumer and business confidence. The Trump trade could play a significant role in driving the profitability of U.S. corporations. Unlike the struggles with health-care reform, we may see less resistance to pro-business initiatives such as tax reform, deregulation, and infrastructure spending.
Unlike the struggles with health-care reform, we may see less resistance to pro-business initiatives such as tax reform, deregulation, and infrastructure spending.
Timing remains an uncertainty. While we have seen a vast improvement in confidence from corporate boardrooms and executive offices, it is unclear when — or even if — that confidence will translate into action, such as capital spending, which has been sluggish since the 2008 financial crisis. The newfound post-election enthusiasm for business growth may be enough to keep corporate profits strong, but progress from Washington on tax reform and deregulation would certainly provide additional support.
Also, while corporate earnings are still growing, we need to keep an eye on wage inflation and other potential cost increases for businesses. Other risks to growth include a strengthening U.S. dollar, higher interest rates, and inflation — all of which can signal an end to a growth cycle.
Exuberant investors have made stocks expensiveEarnings growth takes on added importance when considering today's elevated equity valuations. While we wouldn't describe price-to-earnings multiples as alarmingly high, we believe equities are far from cheap. In our view, earnings and equity prices can move higher even with stretched valuations, but fundamental research and stock selection become more critical in this environment.
Investors viewed the Fed's recent interest-rate hikes as validation of economic strength rather than a precursor to the end of a growth cycle.
Among the sectors that interest us heading into the second quarter is financials. The sector had a strong run at the close of 2016, soaring in the post-election rally and returning 20% for the year. Among S&P 500 sectors last year, only energy performed better than financials. Although stocks of financial institutions weakened toward the end of the first quarter, we believe they have room to advance further. In our view, their valuations remain reasonable, and banks in particular are poised to benefit from higher interest rates, strengthening employment, and growing consumer confidence. In addition, the regulatory burden for financial institutions, especially since the 2008 financial crisis, has become immense and expensive. If progress is made with deregulation, which may not involve overly complex Congressional battles, banks would stand to benefit greatly.
Many stocks in the industrials sector — which are lever-aged to an improving global growth scenario — may also be well positioned for the months ahead. Conversely, we see few opportunities in the more defensive areas of the market, such as consumer staples, utilities, and real estate investment trusts. In our view, these stocks are much too expensive considering their anemic growth prospects.
Federal Reserve is helping, so farSentiment also appears to be positive with respect to Federal Reserve policy, as investors viewed the Fed's recent interest-rate hikes as validation of economic strength rather than a precursor to the end of a growth cycle.
While we do not see catalysts for a severe market correction, we also do not anticipate any significant upside catalysts in the months ahead. However, we believe opportunities are available, especially as equity correlations continued to decline in the first quarter, giving us clearer distinction between winners and losers. In fact, by the end of February, equity correlations — both between sectors and within sectors — had fallen to 2006 levels.