U.S. equities finished mostly higher last week. For a fourth straight week, the S&P 500 and Dow Jones Industrials were up (returning 0.73% and 0.57% respectively for the week), while the NASDAQ underperformed at -0.34%. It was a busy start for second quarter earnings. More than 70% of the 100 S&P 500 companies that have reported earnings have beaten consensus earnings per share expectations by approximately 3% in aggregate.
But we want to watch top-line revenues carefully. Half of the companies have beaten top-line revenue estimates, and overall revenues came in flat versus expectations. The Financials sector outperformed on the back of good earnings reports from credit quality improvement. Technology was the worst performer, with some PC-related companies reporting disappointing results.
Weekly top themes
1. The Fed is repeating the same message, with slight changes to make it more digestible to investors. The Fed does not intend to raise rates for a few years and decisions to taper quantitative easing depend on stronger data. Monetary conditions in most major advanced economies are likely to remain exceptionally loose for several years, even after the U.S. ends QE3.
2. U.S. retail sales missed consensus expectations in June. Nevertheless, they are beating last year's performance on both a 6- and 12-month annualized basis, consistent with an ongoing moderate economic recovery. Leading indicators continue to point to an increase in both sales and investment. Household debt service and financial obligation ratios have fallen to generational lows.
3. The recent rise in oil prices should not be a significant drag on global growth. However, if prices rise much further, this will threaten our forecasts for a gradually accelerating world GDP as we move into 2014.
4. The federal deficit is running $400 billion less than last year. Receipts so far this fiscal year have increased 14% and spending is down 5%. This is primarily due to an improving economy and higher payroll taxes. A budget surplus in a couple of years is not out of the question.
5. China's second quarter GDP slowed to 7.5%. The pace of growth has slowed but was expected as China transitions from a developing to developed nation. The risk in China is not weaker demand but potential policy mistakes.
The Big Picture
The outlook for domestic economic growth will dictate Fed policy, bond yields and equity prices. Risks of economic disappointment imply that bond yields could drift lower and stock prices could face renewed turbulence. However, we believe economic growth should improve later this year through 2014, likely increasing bond yields and equity prices. Housing is no longer a drag and construction has considerable upside. Most state and local government finances are on the mend. Household deleveraging is well advanced and healing in business sector confidence promises faster capital spending growth.
It is widely thought that the Fed's easy monetary policies have been at least as important as fundamentals in driving the equity bull market. While zero short-term interest rates and quantitative easing have certainly played a role, the bulk of the equity performance over the last four years reflects higher earnings. The S&P 500 is currently trading at around 16x trailing earnings, which is only slightly above the historical average. We believe valuation will not constrain prices, but a positive view on the market depends on the uptrend in earnings resuming.
Equity sector leadership is shifting, prodded by the rise in bond yields and improving economic expectations. This shift should persist in the next 6 to 12 months, assuming our forecast of modestly better growth comes to fruition. As a result, we believe investors should consider underweighting defensive sectors and bond-like investments, while overweighting mid-cyclicals such as Industrials and Technology.
Yet risks remain: a faltering U.S. economy, a hard landing in China, a renewed debt crisis in the Eurozone and a spike in oil prices. But the good news is that the first big increase in bond yields has occurred and equities stayed resilient. Perhaps the “great rotation” has begun.
Bob Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management LLC. This commentary originally appeared on the firm's website.