Earnings Matter (Especially Now): July 2017 Market Commentary
- July saw another month of ex-U.S. outperformance in both equities and fixed income largely led by U.S. dollar weakness (Dollar Spot DXY down 2.9% for the month and -9.35% YTD).
- Commodities also benefited from the U.S. dollar weakness led by energy prices as oil continues to recover off its 2Q lows.
- According to the 7/28/2017 FactSet Earnings Insight report, with 57% of the companies in the S&P 500 having reported 2Q17 results, S&P earnings have grown 9.1% on a blended basis.
- The S&P 500 was narrowly led by strong performance from telecom and technology. The rest of the market struggled to keep up with the broad market advance.
- Based on a comparison of tax-equivalent municipal bond yields versus U.S. Treasuries, muni investors may be pricing in a version of tax policy that could be especially punitive to the mid- to upper income segments.
Data Source: Bloomberg
Earnings Matter (Especially Now)
According to the 7/28/2017 FactSet Earnings Insight report, with 57% of the companies in the S&P 500 having reported 2Q17 results, S&P earnings have grown 9.1% on a blended basis. Earnings growth in the U.S. has recovered quite nicely despite the ongoing earnings pressures energy companies are experiencing due to oil price volatility from the second quarter. If energy prices do not recover from their 2Q low levels, then energy earnings decline could accelerate barring any major offsetting cost-cutting measures. On the more positive side, S&P companies are enjoying strong revenue growth which has become a major contributor to overall earnings growth (especially in financials and technology) as opposed to margin improvement (i.e., cost cutting). For all of 2017, S&P earnings are expected to grow 9.5% on top of revenue growth of 5.5%. In addition, fewer companies are issuing negative EPS guidance for 3Q versus the 5-year average.
A peek into market earnings at the macro level can be a useful exercise because earnings ultimately anchor market returns. Your typical fundamental stock picker will tend to focus more on company-level earnings releases but will likely not focus on earnings in isolation without a broad appreciation for how the earnings picture is shaping up for the broader markets. There are moments where markets advance ahead of earnings growth and vice versa, but the two are ultimately tied at the hip.
Exhibit 1 tracks the S&P 500 price index versus basic earnings per share (orange dashed lines) along with the trailing price/earnings multiple. With earnings having largely caught up with the price advance, further market advances will likely rely on earnings going forward given the elevated valuations.
Exhibit 1 – Pay It Forward: Further Market Advances Will Need to Be Driven By Earnings
Exhibits 2 and 3 display price/EPS relationship for international developed stocks (MSCI EAFE Index) and emerging markets (MSCI Emerging Markets Index). Prior to 2017, international stocks have struggled against the U.S. primarily due to a relatively weaker earnings picture. Lack of earnings growth relative to the U.S. helps explain the underperformance of ex-U.S. markets versus the U.S. up until this year.
Exhibit 2 – In 2017, International Developed Recovers as Earnings Recover
Exhibit 3 – In 2017, Emerging Markets Recover as Earnings Recover
July 2017 Market Highlights
July saw another month of ex-U.S. outperformance in both equities and fixed income largely led by U.S. dollar weakness (Dollar Spot DXY down 2.9% for the month and -9.35% YTD). Exhibit 4 displays the weakness of the U.S. dollar as well as euro/dollar spot as the surge following last month’s European Central Bank’s hawkish comments continues unabated. Commodities (Exhibit 5) also benefited from the U.S. dollar weakness as commodity prices have been negatively correlated with U.S. dollar strength in more recent periods. The recovery in commodities had been led by energy prices as oil continues to recover off its 2Q lows helped by reduced inventories as well as iron ore prices following Chinese Premier Li Keqiang’s comments over shutting down lower quality production. Precious metals lagged despite dollar weakness as the global central banks remain committed towards pursuing normalized monetary policies by unwinding quantitative easing (balance sheet expansion through the purchase of debt). Despite this commitment, central bank observers believe financial conditions will remain loose as long as inflation remains subdued.
Exhibit 4 – U.S. Dollar Weakening Continues into July Helping to Drive Ex-U.S. Market Outperformance
Exhibit 5 – Commodity Prices Recover Led by Energy and Iron Ore
Credit continues to be the driver of fixed income performance despite some lingering weakness in the energy sector (Exhibit 6). After having spiked at quarter-end following hawkish central bank comments, long-term Treasury yields and inflation expectations (Exhibit 7) have steadied as inflationary pressures remain subdued despite the Federal Reserve’s commitment to normalize monetary policy which could put upward pressure on longer-term rates. However, the Fed has recently commented that there may be a pause in raising short-term rates, which could offset the tightening effects from the Fed’s normalization of monetary policy. Indeed, the Fed’s balance sheet is expected to remain rate sensitive (relative to pre-2011 levels) as the U.S. Treasury Department has signaled its desire to issue more long-term debt (Exhibit 8).
Exhibit 6 – Credit Spreads Remain Narrow Despite Ongoing Weakness in Energy
Exhibit 7 – Rates and Inflation Expectations May Enter a Range-Bound Period
Exhibit 8 – The Fed’s Balance is Expected to Remain Rate Sensitive as U.S. Treasury Department Seeks to Issue More Longer-Dated Debt
Looking at factor performance within the U.S., ‘momentum’ has retaken its 2017 leadership after having weakened late in the second quarter (Exhibit 9). The other styles continue to struggle versus the broader market partly due to small cap’s weakness relative to large caps (Exhibit 10). However, at the sector level (Exhibit 11), telecom, which had lagged the first half of this year, outperformed all other sectors due to strong earnings releases from Sprint (S), AT&T (T) and Verizon (VZ). The earnings story out of the technology sector is helping to propel growth and momentum styles of investing. Outside of these two sectors, the other sectors struggled to keep up with the broader market (S&P 500 Index) advance.
Exhibit 9 – Momentum Continues to Dominate Other Factors within the U.S.
Exhibit 10 – U.S. Small Cap and U.S. Value Continue to Struggle
Exhibit 11 – Telecom Outperforms All Other Sectors
Muni Bonds Price in Tax Reform – Just Not the Kind You May Be Expecting
Back in February, 3D moderated a panel with fixed income product specialists from PowerShares and First Trust (“Trump versus Bonds Webcast” – as an aside, it looks like bonds are winning). One of the topics addressed concerned the state of the municipal bond market after it had underperformed taxable bonds due to tax reform prospects expected out of the Republican-dominated Congress and Administration (tax reform would presumably reduce the appeal of tax-sensitive assets such as munis). The panelists largely agreed that even with the prospects for corporate and personal tax reform, muni bonds had been priced attractively versus U.S. Treasuries. Indeed, the long-end of the muni curve had higher yields than that of Treasuries, making the tax-equivalent yield (30% tax bracket) especially attractive. Exhibit 12 shows the AAA Muni Bond curve versus the U.S. Treasury curve we originally displayed in the transcript:
Exhibit 12 – Back in February, Muni Bond Yields Were Attractive versus U.S. Treasuries
We bring this up because the muni curve to Treasury curve looks quite different today (Exhibit 13). Despite the Fed having tightened short-term rates resulting in the short-end of the Treasury curve rising relative to the long-end, short to intermediate term munis have barely budged resulting in their tax-equivalent yields (30% tax bracket) to be on par with that of Treasuries from seven years in.
Exhibit 13 – Muni Curve to Treasury Curve Ratio Has Shrunk Since February
We bring this up because the muni bond market provides a useful prospective on how tax reform is likely to take shape. Based on the latest tax proposals being floated by the Trump administration and congressional Republicans, those in the $150,000-$300,000 income bracket would likely see their tax bills rise as estimated by Tax Policy Center (mainly due to the loss of individual deductions, such as state and local taxes). So municipal bonds become even more attractive under this scenario as higher income investors seek to reduce taxable income in the face of a tighter tax regime. However, tax reform prospects may be just as dim as healthcare reform, so it will be interesting to see how the muni bond market prices in the prospects of tax reform for the remainder of the year.
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