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US: The bulls are back in town – BMO CM

Robert Kavcic, Senior Economist at BMO Capital Markets, suggest that it is not a bad year so far for US equities as before heading into the post-Thanksgiving home stretch, the S&P 500 is up 16%, on pace for the second best calendar year of the cycle.

Key Quotes

“Still, that looks subdued when compared to the near-30% run in the Nasdaq this year. And, U.S. stocks are certainly not flying solo, with double-digit gains across much of Europe and Japan. Here are some key factors behind the strength:

Economic growth has accelerated this year across much of the world, bucking some later-cycle signals in the U.S. economy. Overall global growth is tracking at 3.5% for 2017, up from 3.2% last year. Notably, this marks only the second year of accelerating activity since the financial crisis. The U.S., Canada, Japan and much of Europe have all picked up, while China held up better than expected this year.

Stronger growth has helped the earnings backdrop. In the first half of 2017, S&P 500 operating earnings rebounded 20% y/y, the strongest since 2010. Technology is posting its best growth of the cycle, industrial profits have rebounded alongside better M&E investment, and a weaker U.S. dollar since late-2016 has broadly supported the upswing in profits. At the same time, there is little upward pressure on unit labour costs yet, helping to fend off some other later-cycle indicators. This has helped keep valuations in check this year despite strong price gains—they’ve edged up, but prices have largely been supported by underlying earnings across many sectors.

Inflation pressure remains nonexistent, with CPI growth tucked neatly in the 1.5%to-2% range across much of the developed world. While inflation in the traditional sense is absent (i.e., goods and services prices), asset price inflation is running more rampant. Stocks are clearly doing their part, while commodity prices are regaining momentum, real estate is firm, and of course the bitcoin thing. Only if you’ve been hunkered down in the short end of the yield curve have you struggled this year.

Sentiment has been supportive in that equities still seem to be climbing a wall of disbelief, possibly because of two deep scars earned over the past 15 years or so (tech bubble and housing bubble). But that could be changing, with an apparent arms race underway to put the highest 2018 price target on paper heading into year-end. And, the technology story is becoming more compelling (think AI, blockchain, etc.)— who’s still going to the mall? Who hasn’t ordered a Google Home or Amazon Echo?

While monetary policy has begun to tighten around the world, the pace remains extremely cautious. The Federal Reserve, for example, has paused its rate-hike campaign while balance sheet normalization gets underway, and is still whittling down the neutral level of the fed funds rate. A key (and bullish) component of the policy statement remains firmly in place—“the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run”—particularly bullish with the labour market at full employment, and the output gap basically closed.”

“The Bottom Line: Firming economic and earnings growth, little unit labour costpressure (yet), low inflation and still-accommodative monetary policy have created a breeding ground for equity returns. If the Fed doesn’t step up with more aggressive tightening (we think they will, but loaded more toward the second half of the year), it looks like the macroeconomic backdrop will remain supportive.”

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