Reaching the Top of the Wall of Worry
Source: Bloomberg
As we head into the June earnings season, the S&P 500 has finally rallied above the all-time high set in May of last year.
In our letter on June 23, we examined whether U.S. stocks are expensive. We concluded that given the environment of extremely low bond yields, stocks’ price-to-earnings multiples could indeed expand further, given a positive psychological and macroeconomic backdrop.
We have also noted that we see the risk of the next recession drawing closer. A global recession could be precipitated in the next one to four years — perhaps by a devaluation of the Chinese yuan and a subsequent trade war, perhaps by a financial crisis originating in the weak and inadequately recapitalized banks of Europe.
Although that recession risk is still there, factors are converging to support a market rally that could continue for several weeks — perhaps until U.S. election worries begin to come to the fore.
Second-Quarter Earnings Will Have Some Tailwinds
We expect that quarter-on-quarter, earnings will have been bolstered by a weaker U.S. dollar.
In the first quarter, the DXY — an index measuring the U.S. dollar against a basket of other currencies — averaged 97.4; in the second quarter, it averaged 94.6. (Turmoil around Brexit recently pushed the dollar somewhat higher, but not enough to stop a continuing U.S. rally.) The weaker dollar helped U.S. exporters.
Further, U.S. economic growth improved in the second quarter. In the first quarter, the U.S. economy grew at an annualized rate of 1.1%; the most recent monthly survey of economists in The Wall Street Journal suggests that the growth rate picked up to 2.4% in the second quarter.
Source: Bloomberg
Other Fears Are Dissipating
The fears generated by the U.K.’s vote to leave the European Union are dissipating. In our coverage of the Brexit decision, we noted that there remain significant risks to the integrity of the European Union. Dissatisfied Euro-skeptics are now in power in much of central and eastern Europe, and are making electoral strides in western Europe as well, now emboldened by the U.K. vote. Italy faces troubles in its banking system, as well as a referendum on constitutional reform which could lead to elections if it fails to go through — elections that could see gains for Euro-skeptics on both left and right. Hungary will also be having a referendum that may administer a further blow to Germany’s handling of the migrant crisis and widen the fault lines.
However, none of these risks is imminent, and in pound sterling terms, the U.K. markets, as of this writing, have now rallied into bull market territory, having risen more than 20% from February’s lows.
The process of Brexit will be gradual; irrational fears of the devastation of the U.K. economy are fading; a sense of normality is returning. These developments undoubtedly have helped U.S. markets rally. Even so, pessimism, doubt, and fear remain in the background — another normal characteristic that accompanies a rally’s early stages. We would not be surprised to see a rally continue into August and perhaps September, before a correction arrives during the fall campaign season.
Investment implications: U.S. markets have broken out to new highs: will it be sustainable? A few different factors are contributing to a positive psychological shift that could support the rally for several more weeks — and possibly until a fall correction when the U.S. election comes more to the front of investors’ minds. First, fears about the consequences of Brexit are fading, and further European turmoil, while not off the radar, is not visible until later in the fall and into 2017. Second, earnings season is getting underway in the U.S., and second-quarter earnings may turn out to have been supported by a lower dollar during the quarter, and by a pickup in U.S. GDP growth. U.K. and European equities may also participate in a rally; if you choose this avenue, be sure to hedge the currency. As we have noted many times this year, we continue to favor investing in areas that have been beaten down in recent years, or reversion-to-the-mean investing such as Brazilian currency and bonds, and precious-metals related shares. Some big-cap U.S. growth companies are also attractive.
