By Daisy Tolles, CFA, Senior Analyst
The bull market that began in March 2009 recently celebrated its eight-year anniversary, making it the second-longest bull market since World War II. On a price return basis, the S&P 500 was up nearly 250% from the market bottom through the end of March, abetted by record highs set by major stock indexes in early 2017.
Momentum carried over from the end of last year, when the election of President Donald Trump fueled a risk-on rally in the fourth quarter. As markets soared, so did business and consumer confidence – rising to levels not seen in years – on the back of expectations for a pro-growth agenda. Hopes for tax reform, infrastructure spending, and reduced regulation fueled “animal spirits” in the economy. As we have seen, though, fiscal change is harder to come by than investors had hoped. Regardless, with government spending accounting for more than 17% of U.S. GDP, a pickup in fiscal stimulus could support stronger GDP numbers.1 So far in the current expansion, real GDP growth has averaged just 2.2% annually, below the long-term average of 2.8% (Exhibit 1).
Another important contributor to GDP growth is the U.S. consumer, who currently stands on pretty solid ground. As mentioned above, consumer confidence is high – in March, the Conference Board’s Consumer Confidence Index jumped to the highest level since May 2000. Moreover, household debt levels remain low, with debt payments relative to disposable personal income well below the peak level reached in 2007 (Exhibit 2).2 Consumer credit delinquencies continue to be below average as well. Household net worth is also at a record high, thanks in part to the burgeoning stock market that has contributed hundreds of billions of dollars to household balance sheets since the election.
Despite high confidence levels and healthy debt patterns, consumers have still been reluctant to spend. People became cautious after the financial crisis, and this has not yet abated. Inflation-adjusted household spending declined in January and February, resulting in the largest two-month decline since the end of the recession.3 This occurred in spite of rising personal income levels. While income levels rose, so did the savings rate – savings represented 5.9% of disposable income in March. A decade ago, the savings rate was closer to 3% (Exhibit 3).
But the combination of strong confidence, low debt, and rising income levels puts consumers in a strong position to accelerate their spending habits. Consumer consumption accounts for more than two-thirds of U.S. GDP, so if spending were to pick up, growth would likely accelerate as well. In the first quarter, the initial estimate for GDP growth came in at just 0.7%, weakened by sluggish consumer spending, which saw its slowest growth pace since the end of 2009.
While consumer spending has been weak, business investment has been firming, supported by increased confidence and rising oil prices. The National Federation of Independent Business’ Small Business Optimism Index surged in December 2016 to the highest level since December 2004 and remains elevated (Exhibit 4).
Business spending grew at roughly a 9% pace over the first quarter.4 However, we are watching corporate balance sheets. While investors often hear about the robust cash balances at U.S. businesses, most of that cash is held by the largest companies. Apple has nearly $250 billion in cash, which is greater than the foreign currency reserves held by both the United Kingdom and Canada combined.5 Removing the top names, cash levels for S&P 500 companies are actually coming down. Moreover, nonfinancial corporate debt levels are approaching the peak levels seen prior to the last two recessions. Companies have been taking advantage of low interest rates, levering up, and using borrowed funds to buy back their own shares. This has contributed to the run-up in equity valuations, which currently sit above average. At the end of April, the trailing price-to-earnings (P/E) ratio on the S&P 500 was at 21.4x, well above the 16.6x average going back to 1954. Meanwhile, profit margins have been contracting, in part due to climbing labor costs.
Rising P/E multiples have driven equity returns over the past several years, with earnings growth taking a back seat. As a result, the stock market has outpaced corporate earnings – the S&P 500 index level is 18-times greater than forward earnings estimates for the next 12 months. Earnings growth, though, appears to be on the uptrend, assisted by a stronger energy sector. For the first quarter, the estimated earnings growth rate for companies in the S&P 500 was 13.5%, according to FactSet. If that turns out to be the actual growth rate, it will mark the highest growth rate since the third quarter of 2011.6 For all of 2017, analysts have been widening the range of estimates for total S&P 500 earnings, reflecting the potential for decisions in Washington to impact corporate profits and, therefore, investment outcomes. It is uncertain if, how, and when new legislation will unfold and affect growth and inflation. Inflation has been strengthening lately, especially in early 2017 as oil prices rebounded from early 2016 lows. The pickup in inflation has been global in nature, with other economic data improving overseas as well (Exhibit 5).
Confidence levels have been climbing in Japan and Europe recently, along with measures of business activity. Within emerging markets, Chinese growth and economic data continue to surprise to the upside. A synchronized global upturn in growth would inject new momentum into the bull market. A wider range of possible outcomes in the post-election environment is likely to bring about periods of increased market volatility, especially as we are in the latter innings of the current cycle. We acknowledge that extra innings can last for a while, and several data points support that thesis, including many leading economic indicators. The Conference Board’s Index of Leading Economic Indicators – an index composed of variables that measure future economic prospects – was at a record high in March (Exhibit 6).
As we navigate through this new environment, we will manage risks accordingly in portfolios, continuing to appreciate the benefits of a diversified asset allocation. We also look forward to taking advantage of any volatility that arises, recognizing that market corrections are a normal part of extended bull markets.
Throughout the second quarter, the stock market continued to reach new highs while volatility remained subdued. The first quarter GDP estimate was revised up to 1.2% from 0.7%, and economists continue to expect stronger growth numbers for the second quarter. Meanwhile, inflation has been weaker, despite an uptick earlier in the year. Oil prices have been falling on the back of concerns surrounding the global supply glut. Going forward, corporate profit strength will continue to play an important role in the perseverance of the bull market. For the first quarter, the year-over-year earnings growth rate for the S&P 500 landed near 14%, while forecasts for earnings growth for the rest of the year remain strong.7 Fiscal progress out of Washington could add additional momentum to the earnings expansion.