U.S. equities finished modestly lower last week with the S&P 500 nearly unchanged. Most of the damage occurred Friday when escalating tensions surrounding Ukraine weighed on sentiment.
Positive dynamics included an improvement in first-quarter earnings metrics, a notable pickup in M&A activity and deal speculation. A broader macro narrative reflects better traction for the recovery and gradual policy normalization. With momentum plays under renewed scrutiny, several Internet, software and biotech companies sold off despite an expected cushion from solid first quarter results.
NEARING AN INFLECTION POINT
Nearly 50% of S&P 500 companies have reported earnings, and 73% have beaten consensus earnings per share expectations, slightly above the recent trend. Companies are beating estimates by almost 5% in aggregate, above the one-year average of approximately 3%. A notable positive change occurred from the slightly negative surprise rate earlier in the quarter.
(See also: Fear of rising rates hits high dividend-paying stocks)
U.S. economic data seems to be at an inflection point. Most of the Purchasing Managers Index monthly data have shown an uptick, and anticipatory measures argue this is the beginning of a new trend. An uptrend in leading economic indicators is usually synonymous with risk-on markets. Generally, cyclical sectors such as industrials and technology lead equities, bond yields begin to drift higher and eventually earnings start to improve. Markets will likely abandon their obsession with counter-cyclicals and start to bid up investments with U.S. economic leverage. If we are correct, April will be viewed as the month when economic conditions and markets changed.
• The leading economic index jumped more than expected in March. The drop in unemployment claims and the rise in manufacturing work week accounts for much of the gain. Robust readings for the last two months suggest U.S. economic growth is rebounding after dampened activity during the severe winter.
• Capex grew 10.9% quarter-over-quarter (annual rate) for fourth quarter 2013. Capital expenditures are part of GDP and may finally see a long-awaited bounce.
• Why are interest rates staying so low? Our thoughts on why rates have remained low include: weak first quarter growth, concerns about an emerging market crisis spurring a flight to quality, or the Ukraine crisis causing a flight to quality to persist, the potential for European Central Bank quantitative easing and a Fed tone that briefly seemed more hawkish. But nominal growth and wage rates are accelerating, which should ultimately cause bond yields to rise.
• We continue to believe growth in dividends — rather than yield itself — will provide alpha for income-oriented investors.
• Momentum seems to be lacking in the current rally.
THE BIG PICTURE
Equity markets have been on the brink of a correction several times this year yet have proven resilient. The macro backdrop is supportive in terms of the economic landscape, current policy settings and likely path of interest rates over the next year. Risk factors hang over the equity market, however, especially geopolitical developments that could trigger a setback considering the undercurrent of investor cautiousness. We would describe equity market action so far this year as a rotation rather than a correction.
After a soft patch during the unusually harsh winter, U.S. economic data has recently improved. The rebound in growth should support U.S. equities, trigger another rise in government bond yields and induce investors to rotate out of cash and fixed income into equities. Despite geopolitical tensions and lingering uncertainties about growth in China and Japan, the U.S. stock market has endured. Measures of breadth have stayed reasonably healthy, and leadership has started transitioning away from secular growth toward cyclical value, which reinforces a positive outlook for the economy and earnings. As a result, we maintain a moderately pro-growth posture.
Robert C. Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management.
