It was a refreshing break in July as the stock market was moved by ‘traditional drivers’ such as corporate earnings, as opposed to U.S. politics, Brexit or the ongoing myopic focus on the actions of global central bankers.   While the news on corporate earnings was not particularly good, with year-over-year earnings down for the 5th straight quarter, most of the results have come in ahead of the very low expectations.  The weakest results came from the energy companies, which were dealing with much lower oil prices than a year earlier.   Banks also saw year-over-year earnings declines as they had to deal with slower loan growth and record low interest rates, which does not help their profitability.  The upside surprises came mostly from the technology stocks where the global economic slowdown did not seem to have any noticeably adverse effects on the time people spend online or corporations invest to upgrade their systems and migrate business to ‘cloud-based’ services.

The net result was a strong month for stocks across the world as shown in the table below.  While major stock markets in Germany, France, Japan and China all still remain in negative territory so far in 2016, the losses were clearly reduced.   Canada continues to stand out as the strongest performer of the majors this year, lead by a recovery in the resource sector. That followed five years of poor performance for the main Canadian index, which had lagged global indices since the Greek financial crisis and Fukushima accident in 2011.

Major Markets as at July 29, 2016

While stock investors did breathe a ‘sigh of relief’ in July, we remain wary of the outlook for stocks.  High valuations, slowing growth and falling profits in an environment where financial assets have been supported mainly by excessively low interest rates creates more risk than reward potential.  We would be more comfortable investing in stocks if it looked like the economic recovery was starting to take hold but we have actually seen a downgrade in global growth over the past few months.  More importantly, profit margins also appeared to have peaked for this cycle as input prices, such as wage and material costs, are starting to rise.   The chart below shows the profit path of U.S. corporate earnings over the past 15 years (the grey areas in the chart are periods of recession).  Earnings experienced their sharpest decline ever during the financial crisis in 2008, but then recovered almost as quickly as low interest rates and major stimulus programs helped the global economy bounce back from the downturn.  However that impact is wearing off and earnings have seen five straight quarters of decline.  Stocks, though, have continued to move higher and we question how sustainable those gains are.  Either earnings need to reverse to support the move in stocks, or stocks would appear to have some moderate downside risk, at the least!U.S. profits muted by energy/financials weakness

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