Looking Past the Election
- Investors are paying close attention to the U.S. election, with stocks shifting alongside the polls. Traditional market fundamentals have taken a back seat for now, but we believe those signs are pointing to a continuing bull market.
- Whatever the election results, investors should remain calm and recognize that the United States has withstood many leaders and political alignments and still managed to grow—and we believe this time will be no different.
- Wages show signs of rising, but that doesn’t necessarily mean profit margins have to contract significantly.
This will be the last Market Perspective before the U.S. Presidential election—and we were beginning to wonder if the end would ever come! Many of you have likely already voted and we want to remind investors again that it is a great thing to see leadership transfers in a peaceful and orderly way—that is not the case at many places in the world. For those nervous about what the results may be, we urge calm and patience. Given the polling numbers and betting markets, the stock market appears to be expecting a Clinton win and continued gridlock, with at least the House remaining in Republican hands. If the results are quite different than expectations, market volatility could surge, but we suggest investors hold tight. Much as we saw following the Brexit vote, reacting in a kneejerk fashion can be detrimental to longer term performance.
Likely due in part to election uncertainty—but also the muscle memory of the financial crisis—investors continue to cast a skeptical eye toward the stock market; despite the continuation of the 7+ year bull market. According to the Ned Davis Research (NDR) Crowd Sentiment Poll, investor sentiment remains neutral, while according to a Bank of America survey, fund managers are holding more of their assets in cash now than at any time since November of 2001. And the latest data from the Investment Company Institute (ICI) on mutual and exchange-traded fund flows shows the largest outflow from U.S. equity funds since the tumultuous August 2011 period.
This continued skepticism helps to support our bullish case as sentiment is traditionally a contrarian indicator, while also meaning that there is a decent amount of cash on the sidelines which can easily be put to work. Pullbacks are likely (and healthy), but we don’t see signs of an impending bear market unless recession risk rises significantly.
In other news…
Beyond the election, which has used up most of the media space recently, third quarter earnings season is beginning to wind down. Broadly, this reporting period has produced mixed results showing that stabilization is occurring in beaten down areas such as energy; but caution still remains with few companies willing to get too optimistic with near-term projections. It appears earnings will break the five quarter string of negative year-over-year comparisons, which would be a fundamental positive.
Economic data continues to support a sluggish growth narrative, although there are glimmers of hope that we could see at least a modest acceleration in 2017. The rig count continues to bounce back, which indicates a rebound in the energy market and could help to support an uptick in capital spending in the coming year.
Source: FactSet, Baker Hughes, Inc. As of Oct. 26, 2016.
Additionally, the U.S. consumer appears to be gaining some confidence. The recent Consumer Confidence Index release from the Conference Board showed adip from the 104.1 level seen in September, which was the highest level since the recession down to 98.6 but we expect that to be a temporary blip. The housing market also continues its grinding improvement, with existing home sales moving higher by 3.2%, continuing a broad upward trend. The National Association of Realtors has noted that sales are still being held back by low inventory levels. On another potentially positive note that could signal a shift in Millennial thinking, the percentage of those buyers who were first time purchasers rose to 34% from 31%.
Source: FactSet, National Association of Realtors. As of Oct. 26, 2016.
In another sign that there could be a shifting of lifestyles from apartment living to home buying, the housing starts number fell 9.0%; but looking inside that reading, single family starts actually rose 8.1%, while the volatile multi-family reading fell 38% according to the U.S. Census Department. And boding well for the future, building permits—a key leading economic indicator—rose 6.3%.
On the other hand, auto sales appear to be slowing, and retail sales gains are relatively modest, with sales ex-autos and gas rising a tepid 0.3% in the latest month.
Source: FactSet, U.S. Bureau of Economic Analysis. As of Oct. 26, 2016.
Businesses remain cautious, with capacity utilization coming in at 75.4%, below the long-term average; while regional manufacturing surveys such as the Empire and Philadelphia Fed indexes continue to hover around the dividing line between expansion and contraction.
The Fed’s itchy trigger finger
Barring a surprise move at the November 2nd meeting (which could jolt the market as odds of a hike at that meeting according to market measures remain below 15%), the focus on the Federal Reserve (Fed) will move back to the forefront following the election, with all eyes on the December meeting. Fed members have been preparing the market and investors for a hike, and we believe, after several false starts, it will actually follow through this time around. Perhaps equally as important will be the message the Fed sends around the next two meetings regarding what it may be looking to do into 2017.
Rising wages and profits
The Fed believes the unemployment rate in the Untied States is nearing what it calculates to be “full” employment. We are also expecting unemployment to continue to fall gradually in the Eurozone, Japan, and the United Kingdom. That said, the prospects for wage growth in these four economies vary considerably.
- U.S. wage growth has already shown signs of picking up with average hourly earnings (AHE) accelerating to a year-over-year pace of more than 2.5%, as the economy approaches full employment. An increasingly-popular alternate measure of wage growth put out by the Atlanta Fed shows wage growth running more than a full percentage point higher than the AHE measure.
- Falling unemployment in the United Kingdom, to near a 35-year low at 4.9%, has already caused wage growth to accelerate. UK wage growth averaged 2.7% in the past 12 months through June 30, up from 1.8% a year earlier. However, the risk to job growth posed by Brexit may mute the pace of wage gains in the year ahead.
- Japan’s unemployment rate is the lowest in 20 years. Wages have been falling on average for the past 10 years, thanks to deeply ingrained low inflation expectations; but that may be starting to change.
- In Europe, unemployment has fallen by two percentage points over the past three years. Unlike other parts of the world, the Eurozone unemployment rate is not below average. While labor conditions are stronger in northern countries like Germany, this is offset by much weaker job markets in southern countries like Spain and Italy helping keep overall wage growth in the region subdued—for now.
Source: Charles Schwab, Bloomberg data as of 10/26/2016.
While overall wage growth may generally be subdued, a steadily tightening labor market may mean rising wages in the years ahead. Since labor makes up the largest share of corporate expenses, investors are concerned about a meaningfully negative impact on profit margins. Fortunately, that is unlikely to be the case.
As you can see in the chart below, over the past 10 years wage and profit growth in the Eurozone have moved together, not inverse of each other. This has also been true in the United States, United Kingdom, and Japan.
Source: Charles Schwab, Factset data as of 10/26/2016.
Why does a rise in the biggest cost to businesses not reduce profits? Think of it this way: if just one company raises wages it may hurt its profit margins, but if most companies do it, it can lift aggregate demand. Better sales growth driven by a combination of higher volume and prices act as an offset to higher costs. The potential for stronger wage growth is not something investors need to fear—profits may rise next year along with wages.
Stay calm and carry on. We believe U.S. earnings and economic growth will continue to support an ongoing bull market, but gains will likely be modest and pullbacks should be expected alongside political and monetary policy uncertainty. Globally, wage growth is picking up, but that doesn’t have to mean bad news for profits.
© Charles Schwab