Corporate earnings are in full swing, but even with a strong showing out of a large swath of companies, stocks have struggled to move higher at times, in large part because expectations are still elevated. And while there are still strong tailwinds that could keep earnings growth in check, Charles Schwab, one of the leading online brokerages, warned that those tailwinds could actually lead to headwinds that may not bode well for stock investors.
“A mostly-positive economic backdrop has raised inflation and inflation expectations, and could push the Fed to move more aggressively,” wrote the team of market strategist at The Charles Schwab Corporation (SCHW) in a recent report. “Commodity prices have moved higher, the labor market remains tight, and increased fiscal stimulus has caused several key inflation indicators to move above the Fed’s 2% target.” That’s even with the corporate tax cut signed into law late last year and a pickup in repatriation efforts to bring back cash held overseas, which is expected to support more growth in earnings.
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According to Charles Schwab, while the minutes from the most recent Federal Open Market Committee meeting indicated that the Fed isn’t too concerned about inflation, an interest rate hike in June is a “near-certainty,” while Schwab doesn’t think the Fed will act during its May meeting.
In addition to rising inflation, another potential headwind is the political environment, which continues to be dicey given the midterm elections are still a few months away. “Historically, the average loss of House seats in the first midterm for a newly elected president has been 29 according to Strategas Research; so that potential for turnover can help contribute to investor nervousness,” wrote Schwab. “The average maximum drawdown by the S&P 500 during midterm election years since 1950 has been 17%, with weakness concentrated in the first three quarters of those years.” On a more positive note, the brokerage noted that the average subsequent one-year performance has been 32%. “We certainly can’t be sure that history will repeat itself – especially in an era like this – but any election-related weakness could be followed by a rally thereafter,” noted Schwab.
As for a rise in oil prices, which in the past had all sorts of economists concerned about the impact pricier gas would have on consumers and businesses, this time around, it’s not expected to have as negative of an impact. Schwab noted that the tax cut is offsetting some of the higher prices at the pump for consumers, while a doubling of oil production in the U.S. during the past 10 years means that some businesses benefit when prices go higher. What’s more, Schwab said that other parts of the world seem to be doing okay, even with oil prices increases.
“Headwinds for stocks have risen, but tailwinds also exist, resulting in a more tumultuous environment. We believe there are enough positives to keep the bull market going, but gains are likely to be slower in coming, volatility is likely to remain elevated and discipline to a long-term plan will be crucial,” wrote the Schwab strategy team.