One simple word: earnings.
With 93% of S&P 500 companies having reported third-quarter results, earnings are set to contract 1.8% from the year-ago period, according to FactSet. For the year, FactSet estimates that earnings will decline 0.3%, the first full-year decline since 2009.
The primary culprits for the decline are energy and industrial companies. The plunge in oil prices, 45% year-over-year for a barrel of West Texas Intermediate crude, has decimated earnings for energy companies, which FactSet estimates will decline 58.5% for the year. The strong dollar and weak global demand for commodities has hurt industrial companies. Firms are retrenching, like Caterpillar’s recent announcement that it will lay off 1,500 employees, or 1.7% of its workforce.
However, excluding energy, earnings for S&P companies are expected to rise 1.6% for 2015. This certainly isn’t great, but considering the strength of the dollar has subtracted several points of growth for most companies it sets up a better 2016 as currencies stabilize. On this basis and with stable economic growth, analysts expect earnings to increase 8.2% next year.
Recent economic data supports this view. Investors are betting that stronger economic data will move the Federal Reserve toward its first interest rate increase since 2006 this December. Federal Funds Futuresput the likelihood at 70%. The Fed decided to delay raising rates in September based on weak international growth and little sign of inflation.
We don’t think an interest rate increase of 0.25% in December will do much to change the outlook for either the bond or stock markets. The Fed outlined its position on an interest rate rise after its late October meeting, saying on October 29 it would decide to raise rates in December based on progress—both realized and expected—toward its objectives of maximum employment and 2% inflation. Investors have seen progress on both fronts and have already done the Fed’s job as 10-year Treasury yields have gone up roughly 0.25%, to about 2.25%. Stock markets expect the Fed to act; if it does not, it would call into question the underlying strength of the economy.
The key for investors is what happens after the Fed raises rates for the first time. Does growth remain stable or fall back? Do wages continue to rise as the labor market strengthens? Does the Fed raise rates too quickly and then retreat if employment markets stumble and inflation doesn’t materialize? We believe any further Fed increases in 2016 will be carefully undertaken without significantly impeding growth of the economy, profits, and hopefully, stock prices.