The first seven months of the year have been kind to risk assets despite a lackluster economic backdrop. The fact that these stock market gains have occurred alongside record-low volatility has made some investors nervous that a pullback is lurking just around the corner. However, today's low levels of volatility can be explained by the Fed trying, and succeeding, in creating a more stable environment for the markets.
We do know that low volatility does not last forever. With this in mind, we continue to focus our attention to "macro" level movements. Below are a few of the key movements that have our attention:
- International Growth: International Equities have outpaced U.S. Equities during 2017…and for good reason. Economic growth has finally begun to increase overseas and they are behind the U.S. in valuation expansion. To illustrate, the S&P 500 currently trades at 17.7x forward P/E vs. a 14.4x forward P/E multiple for the All Country World Index-ex U.S. Couple this with more accommodating monetary policy and further room for economic expansion (unemployment rates at 9.1%) and you have an intriguing story.
- Sales: Second, let’s look at foreign percent of sales, or the amount of revenue that a sector derives from international (non-U.S.) markets. Since we believe in a story of global growth, particularly in Europe, you may benefit from investing in sectors that have a high exposure to international markets. These sectors include technology (57%) and materials (53%). If the international economy continues to perform well, these sectors should see some benefit.
- Interest Rates: Domestically, let’s look at correlations to Treasury yields. We believe that the Fed will continue to normalize monetary policy over the remainder of the year, and that this will entail a balance sheet reduction beginning in October. Based on data from 1963 to the present, the correlation between movements in interest rates and equities has been positive when the 10-year U.S. Treasury yield is below 5%; however, once rates cross this 5% threshold, the correlation turns negative. With the 10 year Treasury yield currently around 2.3%, there is plenty of room for rates to rise before they begin to weigh on equity market performance. As interest rates rise, we like stocks with a high correlation to Treasury yields. This includes financials, materials and industrials, which tend to benefit during economic cycles with rising interest rates. We want to avoid utilities and consumer staples, which have a negative correlation with interest rates and therefore tend to perform worse when rates are rising.
- Earnings: During Q2 2017, the blended earnings growth rate for the S&P 500 was 10.2%, with revenues up 5.1%. Given these healthy Q2 earnings results, it seems reasonable to declare that the earnings recession is officially behind us. While increased equity valuations still make us nervous, the increase in earnings growth is critical because without true earnings growth the bull market is simply not sustainable.
What lies ahead for the U.S. equity market? Should we be worried that volatility is so low? What is happening in Washington? Is there a recession around the corner? The bottom line is that in a very noisy world, the best thing an investor can do is focus on the signals rather than the noise. The signal to us is that earnings growth is coming alive and as long as this remains the case, U.S. equities could very well continue to benefit from the fundamental support that this earnings growth provides.
As always, we will continue to monitor.
Reid Davis serves as Chief Investment Officer at Pinnacle Trust. He is also chairman of the Investment Committee. You can reach him by email at [email protected] or by calling the office at 601-957-0323.