U.S. equities finished higher again last week as the S&P 500 increased 0.4%. The
Federal Reserve continued to dominate headlines, with heightened emphasis on the distinction between tapering and tightening. Bubble speculation continued to receive attention in the press, while many articles refuted such concerns. The financial sector performed well, led by banks.
Third-quarter earnings results showed an increase in manufacturing activity, as earnings growth in cyclical sectors (excluding energy) outpaced defensive sectors. Every defensive sector lagged the overall S&P 500, while all cyclicals (excluding energy) outpaced the index. Rate-sensitive sectors continued to thrive.
In terms of share price gains, cyclicals have been outperforming defensives since the end of the first quarter, but analysis reveals the outperformance has been based on multiple expansion rather than earnings. This implies cyclical stocks have room to grow if they can build on this quarter's earnings outperformance.
A key development is the apparent acceleration in the growth rate of S&P 500 revenue and earnings. Although one quarter does not make a trend, the third quarter marked the first in six in which revenue growth moved out of a near-zero range. More data is needed to confirm an inflection, but an improvement would support higher stock prices and take pressure off of multiple expansion.
TOP THEMES
Fourth-quarter retail spending is off to a good start: October total retail sales beat expectations and rose 0.4%. Retail sales, along with the relatively positive October employment report, indicate minimal impact from the government shutdown. The data appears to balance some of the downside risk to fourth-quarter economic growth.
We anticipate either another year of sequester or a deal in December, although it is not certain. We intend to plan for upcoming fiscal restraint. Government receipts are still in solid territory, and new deficit projections from the Congressional Budget Office will show even more progress than expected. The Democratic majority in the Senate substantially changed filibuster rules to prevent the Republican minority from blocking Presidential nominees to government agencies. The change includes the Fed and courts other than the Supreme Court. It will enable the Obama administration to use executive branch powers aggressively but could damage the atmosphere in the Senate, making major legislation such as comprehensive immigration reform less likely.
THE BIG PICTURE
Global growth is improving and we believe it will accelerate in 2014. Progress will be underpinned by diminishing fiscal drag, consumer recovery in the United States and Europe and modest increase in corporate capital expenditures. We are more optimistic about China, where recently announced economic and social reforms should improve economic growth and stability.
Risk assets have continued to rally as the Fed and European Central Bank emphasize a commitment to a low-interest-rate environment.
We expect the Fed to taper, or reduce, its asset purchases in the first quarter. We perceive that a repeat of the May/June correction is unlikely, since valuations and positioning have largely adjusted. In the eurozone, the European Central Bank delivered a surprise rate cut, signaling both a clear divergence from Fed action and continued policy support. The emerging gap between the two central banks should underpin a stronger U.S. dollar.
Equities continue to run higher, as volatility across all asset classes has fallen to pre-crisis levels. Despite rising concerns over market bubbles, equity valuations remain close to long-term averages and equities appear inexpensive relative to fixed income. Accommodative central bank policies can probably support near-term prices, but sustained appreciation will likely require stronger economic growth to subsequently boost corporate earnings. We do expect growth to materialize, and future returns will likely be positive yet muted, as well as more dependent on stock selection.
Bob Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management. This commentary originally appeared on the firm's website.
