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A strong second-half run for U.S. stocks have pushed the major equity indexes into record territory as 2019 comes to a close. Much of this rally was fueled by fundamental factors, including better-than-expected corporate earnings. Stocks also got a boost from the Federal Reserve, which pivoted to a more accommodative monetary policy with three quarter-point cuts in 2019.
Even as the S&P 500 index SPX, +0.11% performed well, investors were for the most part skeptical about the opportunities for investment returns. As an example, money flowed out of U.S. equity funds for much of 2019, while inflows to U.S. bond funds surged. This doesn’t historically happen in the home stretch of a bull market run.
However, there are signs this pessimistic funk is lifting. If so, it couldn’t come at a better time. We believe the bull market for U.S. stocks has more room to run and should continue to push the benchmark indexes higher in the near term.
Here’s why we’re optimistic on stocks in the next few months:
1. The U.S. economy remains strong. The pace of the economic expansion may have slowed in recent quarters, but GDP growth is still positive. Recession fears have largely waned as the Fed cut rates and the yield curve returned to a positive slope.
We’re also approaching the all-important holiday shopping season at a time when labor markets are tight and wages are rising. In particular, lower-wage workers have seen the majority of lift from recent wage gains — their wages increased 5% from the same month last year according to the October 2019 employment report. That’s good news for consumer spending, which continues to drive the U.S. economic engine.
2. “Green shoots” appear in the global economy. Weakness in many large global markets weighed on investor expectations earlier in 2019, but there are emerging signs the slowdown may be at an ebb. Strength in the U.S. dollar has helped drive demand from foreign markets and made international companies more competitive.
Aggressive monetary policy easing by global central banks is also helping to spur growth in many international markets. It may be early to say the global economy averted a slowdown, but the appearance of “green shoots” is encouraging.
3. Company earnings are poised to surprise. Double-digit earnings growth was common a few quarters ago, but expectations for future earnings moderated on geopolitical concerns and blowback from the trade war. The current outlook calls for corporate earnings to grow just shy of a double-digit pace in future quarters.
But these expectations may have softened a bit too much. With fears of a global slowdown lessening and the U.S. dollar peaking, there’s potential for an upside surprise for earnings growth. To that point, management conference calls on third-quarter earnings have been broadly more optimistic than in previous quarters. If earnings surprise do occur, U.S. stocks may enjoy a substantial lift.
4. There’s genuine progress on trade talks. Uncertainty surrounding trade discussions between the Trump administration and the major U.S. trade partners has dragged on company performance. But recent news reports related to trade have given firm managers and market participants reasons for optimism.
Particularly in negotiations between the U.S. and China, it finally appears the two countries are closer to resolving some major trade issues. Any progress would be welcome, not only for the lower tariffs that would likely follow but also for the clarity it would give to the market on the potential for a broader agreement between the two largest global markets.
Just a few years ago, when investor optimism was built on trade, stock rallies were robust but fleeting. Now that trade is part of a broader mosaic of economic growth, stock gains should be more sustainable, which would be an encouraging development.
Where to look for opportunities
From our vantage point, it remains full steam ahead for the U.S. economy, so we are generally optimistic about the prospects for equity returns in the coming months. We are definitely in the later stages of the current expansion, but there’s enough strength in the economy to keep the current growth cycle running and the next recession at bay, at least for the time being.
In the maturation phase of the economic cycle, “quality” companies typically perform well relative to the overall market. These companies have multiple ways to generate returns, whether it’s through margin expansion, acquisitions, buybacks or dividend growth. Look for companies with a strong balance sheet and healthy cash flow generation, particularly in technology, industrials and consumer discretionary. Firms tend to find earnings growth harder to achieve as the expansion wears on. These companies typically do well over a full economic cycle (expansion and recession) because they often have multiple levers to pull to sustain growth and enough strength in their balance sheets to stay resilient.
Historically, these quality companies have outperformed the broad U.S. stock market over the duration of an economic cycle with less exposure to risk. Stocks of these firms are poised to offer better opportunities for investment returns going forward.
Mark Hackett is chief of investment research at Nationwide.
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