What will it take for stocks to move higher? A lot must go right
David Joy – Chief Market Strategist, Ameriprise Financial
Weekly markets commentary — April 23, 2018
Bond yields continued to move higher last week, as the intermediate portion of the yield curve began to play catch-up with the short-end. The most recent move in the ongoing flattening of the yield curve began in the second week of February, when the spread between the two and ten-year Treasury notes was 78 basis points. It bottomed last week on Tuesday at 43 basis points, its lowest since August 2007, and in the process raising anxiety that a possible inversion and recession to follow was edging ever closer. During that time, the yield on the two-year note rose 31 basis points, while the yield on the ten-year actually fell by three.
However, over the final three trading days of last week the ten-year climbed 13 basis points while the two-year rose just six, pushing the spread wider to 50 basis points. And while that move is relatively modest, and so far short lived, it did serve to alleviate some of the recession anxiety that the yield curve had been raising. Whether further steepening is in the cards depends upon a multitude of factors, including rising inflation, heavy Treasury supply, foreign demand, global growth, the relative strength of the dollar and so on.
The move higher in bond yields also raises anxiety for equity markets, as at some level the risk and reward for debt instruments begins to compete with that for stocks. In addition, the present value of future earnings will come under increasing pressure as the curve ratchets higher causing valuation to compress. In early Monday trading this week, the ten-year was yielding 2.98 percent, the highest in four years. A yield of 3.00 has been cited as a possible milestone threshold that could represent a real headwind for stocks. However, if that level is reached less due to rising inflation and more because growth is shown to be firming in the U.S. and abroad, including stabilization in the recent weakness in Germany and Japan, stocks could regain their upward trend. Should growth struggle to accelerate, however, stocks could continue to languish as they have for the past month.
Earnings deliver, but fail to lift stocks from their lethargy
The much vaunted first quarter earnings season has so far been unable to lift stocks from their lethargy. Since earnings season began on April 13 the S&P 500 index is up by all of just 0.2 percent. And while there certainly have been winners and losers, in the aggregate Factset still projects growth of 18 percent in the quarter. As strong as that result would be, it may not be enough. Ever since early January, as analysts were scrambling to account for tax reform in their 2018 earnings forecasts, earnings growth in the high teens for the first quarter has been the consensus expectation, and one must believe, already discounted in stock prices. If that is the case, stocks would need something more. To the extent that companies tend to exceed expectations, when all is said and done first quarter growth could be above 20 percent, and that might be enough to pull stocks higher, all else being equal.
But for all else to be equal, a lot must go right, beginning with the pace of economic growth. The advance estimate first quarter growth will come on Friday, and is expected to be near 2.0 percent annualized. That is not enough to deliver the kind of full-year earnings growth that equity markets are expecting, not to mention the volume of tax revenue that dynamic scoring proponents require to keep a lid on the federal budget deficit. We expect growth to improve in the second quarter and beyond, as has been the pattern in this recovery, but now we need to see hard evidence of that. The same is true in Germany and Japan, both of which experienced sharp slowdowns in the first quarter. Improved Purchasing Mangers’ Index (PMI) readings from both on Monday are a welcome development.
Investors look for a more peaceful atmosphere on trade
A less contentious atmosphere on trade would also go a long way to alleviating the pressure on stocks. Treasury Secretary Mnuchin is said to be contemplating a trip to China to discuss trade, and dialogue is welcome. Whether it proves to be productive, however, remains to be seen. It would seem that the administration would want to lower the temperature on trade with China as not to interfere with sensitive negotiations regarding North Korea and the rapidly approaching May 12 decision date for remaining in the Iran nuclear accord. If the U.S. does withdraw, and re-imposes sanctions, already rising oil prices can be expected to move even higher, intensifying inflation concerns and generally rising geopolitical tensions.
There is a long way yet to go in earnings season. In the week ahead we will get results from companies as diverse as Alphabet, 3M, Amgen, Coca-Cola, Caterpillar, Eli Lilly, Freeport-McMoran, United Technologies, Verizon, Baker Hughes, Boeing, Comcast, Facebook, Ford, Qualcomm, Amazon, Bristol-Myers Squibb, GM, Intel, Microsoft, Chevron and Exxon Mobil. The domestic economic calendar includes reports on flash PMIs, new and existing home sales, durable goods orders, consumer confidence and sentiment, and personal income, spending and inflation in March. And in addition to active calendars of their own, both the Bank of Japan and European Central Bank meet this week. There is no shortage of potentially market moving events this week.