Earnings, Hopes for Policy Change Drive Markets Higher

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Bob Johnson, he is our director of economic analysis, for a look at the markets and what's driving them.

Bob, thanks for joining me.

Bob Johnson: It's great to be here today.

Glaser: So, now we're past the first quarter. When we look across the major asset classes--stocks, bonds, commodities--what's happened with performance? Are we still seeing kind of strong numbers across the board?

Johnson: Well, we're seeing very good numbers in the stock market, perhaps not as hot as late 2016, but stocks are still clearly outperforming and were the best asset class during the first quarter. Bonds were also up in the first quarter, not nearly as dramatically, but still a bit of a surprise. With the one Fed rate increase in December and then yet a second one, there was a lot thought that this would not be a great year for bonds. But bonds have actually had a decent total return in the 1% territory. So, certainly, no slouch either.

The only sector in the first quarter that didn't look as good was commodities, which was driven a lot by oil, which, as drilling picked up here in the U.S. and we went through a warm winter here in the U.S. that kept usage down, those things kind of aligned to make it difficult for oil prices to go much of anywhere. And so, we did have a relatively rough quarter for commodities. So, stocks were certainly the place to be.

Glaser: Looking at those big stock numbers, is that being driven by kind of irrational exuberance, hope for changes in, say, the tax code and regulations, or are we really seeing that in earnings and it's pricing in a better business environment?

Johnson: I'm going to give you a mixed answer on that. There is a little bit of both going on. I think there was a lot of sentiment and hope for policy changes that boosted deregulation and cut taxes and perhaps did something on the import/export side--would all be things that might be helpful to the economy. All of those measures have taken a little bit longer than people thought and may not be as extreme as people thought. So, that certainly has come in some of that thinking a little bit. It has put a little short-term pressure, at least a lid on the stock market, if you will.

But on the other hand, the earnings are finally looking better. The S&P 500 earnings in the first quarter right now are anticipated to be up almost 10% and that would be the best performance since 2011 on a quarterly basis when the number was about 11.6%. So, it's not totally irrational if earnings are supposed to be the key driver of markets, earnings are getting better. I would caution there that a bunch of the earnings improvement is in the energy sector which had been doing so abysmally a year ago. It was the worst possible time that perhaps that's inflating the numbers. So, you, kind of, take that out of it, things aren't necessarily a whole lot better than they were before, but they are some.

Glaser: Let's look at stock markets across geographies. Where are the big gains coming from?

Johnson: Yeah. And we've had a little shift in that, but again the biggest shift has been emerging markets. They had a rough year last year, and now this year they are one of the best performers, up about 14% year to date. So, emerging markets have really turned the corner. Europe has also done quite well. Now, I'm going to push them a little bit past the first quarter. We had this election to get through in France, but now European stocks are up about 11% year to date, which both of those numbers, the emerging markets and Europe, are clearly ahead of the 6% or so that we're seeing in the U.S. data. So, clearly, by geography, things shaped up a little bit differently than people thought.

Glaser: Looking across sectors, what parts of the market are doing better? Are we still seeing those same areas that rallied at the end of 2016, like financials, continue to drive the market?

Johnson: No. I mean, we've seen a little bit of a shift of what's doing well. Certainly, tech had a great year in 2016. But so far in 2017, it's also done well. I think it fits in with our demographic--labor shortage, people wanting different things--has all helped the tech stocks do just a little bit better here. And so, they are probably the strongest performer here in the first quarter up maybe 12%, 13%. So, that's clearly the strong news, that was the strong sector last year.

On the other hand, you've got, as you asked about, the financial services sector from last year had two benefits: a potential deregulation coming after Donald Trump's election that was anticipated, and then the other thing being higher interest rates which allows them to get a bigger spread and provide some real opportunities to expand their earnings without expanding their costs a great deal. So, there was a lot of excitement about those stocks last year. On average, they were up about 32%.

This year in the first quarter they are only up 3% as that deregulation has been a bit slower in coming than people had hoped. And in addition, interest rates are actually down from the end of the year instead of being up as so many of us have anticipated. So that spread has not widened as dramatically as what we thought, although banks did have a good set of first-quarter earnings reports. So, they are not doing horribly on that front. Nevertheless, some of that big, huge tailwind that was expected from deregulation and from a big boost in interest rates just hasn't hit. So the stocks have underperformed.

Glaser: Let's talk about rates, talk about the bond market a little bit. It seems like those are moving in the opposite direction, maybe the bond market is looking at different set of data than the stock market. How do you explain kind of these two somewhat divergent stories here?

Johnson: Yeah. I think the bond market has done relatively well given all the circumstances, and I think there's a few things going on. I mean, April was a little bit of a hard month to judge. There was a little bit of a flight to safety move into the U.S. bond market in April as there were worries about the French elections and various international situations. So, that may have helped depress the interest rates a little bit. But still, I think the interest rates have been a surprise to all of us that they haven't moved up just a little bit higher.

Glaser: So, taking all of this in, when you look at the markets, do they seem to reflect what you're seeing in the economic reality? Or do you think that we're looking at valuations are just too stretched in stocks and that we're going to see some dislocations in the bond market as well?

Johnson: I think valuations are stretched. By our metrics and our price/fair value, we're at relatively high levels that we don't see very often. I mean, they are not outrageously overvalued, but they seldom get that way. It's near where things have peaked at before. So, on a valuation basis, we continue to be worried. But again, there aren't a lot of other opportunities anywhere else. And with so many baby boomers now retiring and wanting decent retirement income, you're seeing a situation where, well, where am I going to put my money in? So, that's certainly helping affect the markets.

Certainly, we had a big positive run in everybody's sentiment that everything was only to go upward and onward, and I think in the U.S. we've had a very serious dose of reality here. The numbers for March in particular that we've seen over the last week were surprisingly soft. I don't think that one single month should be taken out of context, but certainly what we've seen so far this year and particularly, in March, is not indicating a new boom era. It's indicating perhaps even some modest deterioration in what's going on out there. So, certainly, the U.S. economic activity has gotten just a little bit worse. Overseas activity has also managed to pick up in light of that. We had growth out of China this week at 6.9%. Everybody thought that was on a one-way track down a year ago to 5% or 6%. We can argue how they got there, but that 6.9% growth there puts that one fear aside and some better expectations and then the big news is really Europe has done a lot better than anybody anticipated.

Finally, the low euro has kicked in and their exports did very well. Well, now that everybody finally believes that the businesses are actually hiring people to fill those orders they've gotten over the last six to 12 months, and that's increasing employment to the highest levels seen since 2000, according to some reports. And certainly, with that number getting better, there is more consumer spending going on. For real change when we're reading GDP reports of various European countries, we were seeing there was good internal demand for products. So, certainly, we've seen better economics in Europe, not so much in the U.S. and that perhaps explains why the European and emerging-markets stocks have done so much better than those in the U.S. recently.

Glaser: Bob, thanks for your update on the markets today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.