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Fundamentals press on despite risks

At times like these, when the two primary — and, arguably, only — drivers of equity market performance are acting in opposition, it is critical to understand the hierarchy of influence.

Markets and investors are perplexed. Corporate earnings have been shining brightly for more than two years, while other critical fundamental metrics such as revenue more recently have begun to exhibit massive strength, thanks to robust worldwide demand. For much of 2011, however, global risks — everything from the unstable macroeconomic and geopolitical environment to natural disasters — have conspired to undermine this impressive fundamental groundwork. The end result has been highly volatile but ultimately flattish equity markets.

At times like these, when the two primary — and, arguably, only — drivers of equity market performance are acting in opposition, it is critical to understand the hierarchy of influence. Although spikes in global risk may make for splashy headlines and temporary shocks to investor confidence, the market’s path ultimately comes down to the strength of the underlying fundamentals.

One need only look at the events of the third quarter to get an idea of the instability endemic in the financial system. The U.S. lost its pristine triple-A credit rating and was put on negative watch by Standard & Poor’s after much political brinkmanship over the debt ceiling and deficit reduction. Congress, meanwhile, remains a portrait of dysfunction as political gridlock continues to thwart the establishment of much needed pro-growth economic policies and spending restraint.

Europe spent months trying to contain its debt crisis before finally making concrete progress toward the end of last month, as private investors (mostly European financial institutions) agreed to a larger haircut on their Greek debt holdings. In addition, banks will be required to raise new capital to insulate themselves from potential future crises, and the capacity of the region’s rescue fund will be expanded to the “shock and awe” level of 1 trillion euros. While global markets reacted enthusiastically to the news, Europe’s troubling debt dynamics and weak economic growth remain longer-term stumbling blocks.

Despite significant head winds, market fundamentals have forged ahead. Taken in the context of our current “ABCD” perspective on the market, the trends are quite compelling.

Accelerating corporate profits. For each of the past nine quarters, 70%-plus of the S&P 500 has delivered positive-earnings surprises. For full-year 2011, S&P 500 earnings are on target for a record $96.50 per share.

Booming manufacturing. Despite the familiar lament that “we don’t make anything anymore,” U.S. manufacturing continues to be a powerhouse. It has expanded for 26 consecutive months, driven by global trade and, in particular, emerging-markets growth. Meanwhile, U.S. exports surged to an all-time high of $178 billion in July.

Consumer strength underestimated. Even with unemployment above 9%, the U.S. consumer — who accounts for 70% of gross domestic product growth — remains a potential game changer. U.S. retail sales are at their highest levels ever after seven consecutive monthly increases, and the September tape shows a jump of 7.9% over the year-earlier level. A boost in hiring could further encourage consumers and singlehandedly change the dynamics of the markets.

Developing economies driving global growth. Emerging markets are a key catalyst for U.S. corporate revenue. China reported third-quarter GDP growth of 9.1%, disappointing for China but ridiculous by any other country’s standards, and imports increased 30% year-over-year in August. In Brazil, second-quarter retail sales improved 7% over the first quarter, thanks to robust labor and credit markets. And real quarter-over-quarter GDP growth for the host nation of the 2016 Summer Olympics came in at 5.1% for the first quarter of this year and 3.3% for the second.

Global risk is rampant, its ebbs and flows driven by the misplaced expectation that politicians have all the answers. While only market-oriented reforms can solve market-oriented problems, risk and uncertainty could be reduced greatly by pragmatic political decisions — both here and abroad.

In the meantime, investors would be well-advised to disregard the noise and remain focused on the primary driver of markets — fundamentals. With U.S. corporations the primary beneficiary of global growth (and emerging-markets growth, more specifically), we are partial to domestic equities. Superior earnings trends should power the outperformance of mid- and small-cap stocks, with the consumer discretionary and technology sectors in particular benefiting from a stronger consumer demand in 2012.

Douglas Coté, a chartered financial analyst, is chief market strategist for ING Investment Management Co.