Happy to Get Midterms Over With

11.07.2018 - Carin L. Pai, CFA

  • The US midterm elections resulted in a split decision, with Democrats gaining a small majority in the House of Representatives and Republicans strengthening their Senate majority beyond what most pundits expected.
  • This result should be positive for markets overall as divided governments have historically proved to be a fruitful backdrop because of the increased stability they provide.
  • Although, this result is likely positive for US fiscal continuity, it is unlikely that we will see further action on the policy front. Additionally, it makes it very unlikely that tax cuts will be rolled back due to the larger Republican Senate majority.
  • While Washington policy can always impact markets, we believe this outcome will allow investors to shift focus back to economic and corporate fundamentals for the time being.

With midterm elections out of the way, there is one less uncertainty now hanging over the US stock market. Investors can now turn their attention to developments that may have a more prolonged impact on market prices - such as the strong corporate sales and earnings figures we are seeing for the third quarter of 2018. 

Now in the home stretch of the earnings season, roughly 78% of S&P 500 companies reported better-than-expected earnings growth for the third quarter, and 59% have beaten sales estimates. Third quarter earnings growth will likely result in a 23% growth over last year. Guidance for 2019 remains at about 10% growth. All these factors tell us that the economy is healthy and corporate earnings should continue to grow, albeit at a slower pace than we saw earlier in the year.

Fears Versus Fundamentals: A Noisy Market Creates Distractions

This raises the question: If fundamentals are so good, why has the market been so volatile? Part of the answer is the extraordinary profit growth we saw earlier this year is ebbing, and investors are resetting their expectations accordingly. But there is also a lot of noise and uncertainty distracting investors from the fact that fundamentals remain relatively strong; including concerns that the Fed might raise rates too aggressively, tariffs could disrupt global supply chains, and profits could sharply decline.

However, in our view, the macroeconomic backdrop has not changed in any meaningful way since market volatility resurfaced in October. This view is supported by many of the observations and comments we heard from CEOs and other corporate leaders on third-quarter earnings calls. Generally, the tone is a bit more cautious in terms of profit margins, but companies are retaining a fairly positive outlook.

Tariffs Have Minimal Impact on Corporate Balance Sheets

Similar to the trend that took shape in the second quarter of the year, some companies reported that higher costs for raw materials from modest inflation and tariffs, a stronger US Dollar, and marketing/advertising weighed modestly on profit margins in the third quarter. In addition, while some companies see tariffs as a potential challenge for 2019, they are also making plans to address the costs by changing suppliers or finding new manufacturing locations. In some cases, they are passing the costs with plans to raise prices.

All in, the fears regarding tariffs appear to be manageable and contained to specific industries, which could help minimize any disruptions to the global supply chain and provide some relief to investor confidence.

Corporate Weakness Appears Isolated to Certain Industries

Pockets of weakness in the US economy also appear to be isolated. Among companies that reported mixed or disappointing financial results for the third quarter, many pointed to a specific geographic market, such as China, or rate-sensitive end customers such as the auto industry or housing market. Additionally, almost half of all S&P 500 companies mentioned the stronger US dollar as a headwind, with some companies predicting currency volatility could persist into 2019. The Industrial sector and Technology sector are important barometers for the economy and the market, given the international exposure they have and the targeted nature of the tariffs, which affect the industries within these sectors. So far, earnings season provided some relief to the worst fears.  

The bottom line is that certain market sectors, industries and companies appear better positioned for success than others in this economic landscape. Investing with a high degree of selectivity is essential.

Our Conviction Remains in Growth Areas of the Market

Although earnings continue to grow, companies have been reining in their expectations. With this in mind, market return expectations are also moderating and valuations are returning to more "normal" ranges. This could present buying opportunities.

Industrials are seeing strong demand for products and services from the aerospace industry, defense companies, heavy construction firms, energy processors, e-commerce and the healthcare industry. And we expect the tech sector to benefit from strong capex spending as corporations make some long-overdue infrastructure improvements.

To be clear, the US equity market faces several headwinds, and we expect volatility to persist as the political landscape in Washington shifts, rates approach their target and trade policy evolves. Therefore, we will be carefully monitoring both market sentiment and corporate fundamentals throughout the remainder of the year. Our goal is to manage the risk that comes along with market volatility while also capturing the durable growth opportunities it so often reveals.

Kyle Hutchinson, Chief of Staff, Office of the CIO, contributed to this article.

This communication is intended solely to provide general information. The information and opinions stated are as of November 7, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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