Capital Market Comment
May 9, 2017
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
The equity market making new highs has raised more questions and doubts than one might expect. Historically, market highs generate their own enthusiasm which often sows the seeds of euphoria that ultimately prove to be the undoing of a rising market.
The more recent increase in equity prices appears to be mostly related to the recovery in earnings growth and evidence of revenue beginning to participate in the growth cycle. Over 80% of the companies reporting Q1 earnings have beaten estimates, and more than half have exceeded their revenue projections. Moreover, guidance has been more upbeat than at any time in the last several years. This pattern is quite interesting in the face of an anemic Q1 GDP annualized growth rate of 0.7%. GDP is proving to be less helpful in understanding the underlying strength of the economy than in the past. The seasonal factors continue to plague Q1 and the growth in the digital economy and social media is not being captured to the extent it should be in the GDP estimates. In time, I would not be surprised to see a new metric emerge that is a more comprehensive measure of economic activity.
Employment growth appears to be a better indicator of underlying strength and it continues to record monthly average gains in the 150,000 – 200,000 range, a number above what is necessary to absorb the new entrants into the labor force. Moreover, the diffusion index, which shows the percent of industries adding to employment, stood at 60.2% in April. In manufacturing, it recorded 53.2%. These gains are healthy.
Not to go unnoticed, the international environment is undergoing an upgrade in growth and growth expectations. Once again, this phenomenon is relatively new. The European community has seen GDP growth begin to reemerge in late 2016 and early 2017. The European Central Bank has raised its growth rate slightly for 2017 and 2018, but still remains aggressively accommodative with its bond buying program, which is likely to last all year and possibly into early 2018. This accommodation is producing a 38 basis point rate on the German 10-year government bond. In Japan, the economy has improved slightly and the Bank of Japan remains on its aggressive accommodative monetary policy path with zero (0%) as its target rate for the 10-year government bond.
The Chinese economy appears to have stabilized and is recording a 6.5 – 7% real growth rate according to government officials (whose announcements are always a bit suspect). However, private surveys show growth is continuing, but at a slower pace. Other problems remain in China, most notably the burden that is evident in the credit markets. Yet, forward progress remains.
The improving international environment along with the true underlying strength of the U.S. economy is providing a stronger base for the earnings of U.S. multi-national corporations. Moreover, on the public policy side, the lifting of the growing burden of regulation has unleashed a level of optimism among small and large businesses. This confidence may have already begun to manifest itself in the growth of nonresidential fixed investment in the first quarter with a 9.4% annualized real growth rate. Other fiscal policy measures are yet to be determined and cannot be adequately discounted into the investment landscape. What can be highlighted is that defense and infrastructure spending are likely to experience an acceleration, but the elements of tax reform and its passage remain distant.
The policy that remains the most relevant is monetary policy. In our judgement, the economic expansion that began in mid-2009 should be laid at the feet of the Federal Reserve. The Bernanke recovery, and the Yellen expansion have created millions of jobs and continue to do so. Current monetary policy remains accommodative as evidenced by “real” (inflation adjusted) monetary growth and negative real rates (federal funds rate minus the inflation rate). Although short-term rates have increased as the Federal Reserve attempts to move toward a normal (neutral) interest rate (3%), the increases still place the rate well below the inflation rate which is near 2%, hence a negative rate. Two additional rate increases this year appear to be anticipated by the financial markets. However, the timing is uncertain and the net effect of a 50 basis point increase in two 25 basis point increments will still leave rates comfortably below the inflation rate. In the meantime, the markets are likely to focus upon the growth in the economy and profitability as the justification for the Fed actions and remain fixated on business developments.
Stress in the financial market often proves to be the catalyst that undoes a bull market. The financial stress index developed by the St. Louis Federal Reserve stands at a -1.42, an indication that essentially no financial stress exists. Our own proprietary liquidity stress index is at a particularly favorable level – suggesting little market turmoil ahead. It must always be mentioned that corrections can occur at any time and in unexpected ways. Exogenous events can produce that kind of volatility. However, they generally prove short-lived and the market can recover quickly. What concerns us the most are the stress conditions that foreshadow a “bear” market. The evidence is not there yet.
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors. If you have a question or need further information, please contact:
Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, or patrick@mcapitaladv.com or
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or claude@mcapitaladv.com.
© 2017 Mastrapasqua Asset Management, Inc. All rights reserved.
The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.
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