Robert C. Doll, CFA
Senior Portfolio Manager,
Chief Equity Strategist
Nuveen Asset Management, LLC

Weekly Investment Commentary

Markets Pause While Awaiting Federal Reserve Activity


March 2, 2015
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Key Points

  • The Fed contemplates options but remains idle for now.
  • Interest rate increases, when they occur, will likely cause equity market volatility to rise.
  • A combination of improving global growth and reflationary monetary policy should act as a tailwind for equities.

U.S. equities were mixed last week, with the S&P 500 declining -0.2%.1 The Federal Reserve (Fed) had a busy week, as the nuanced debate continues around when to begin policy normalization. The global policy divergence grabbed headlines, but the focus was mainly on negative yields in Europe and inflows to non-U.S. equities. Following the bounce in U.S. equities over the last few weeks, discussion emerged about potential headwinds such as valuation and near-term Fed tightening. Consumer sectors were the best-performing, while energy, utilities and industrial sectors showed weakness.1

 

Weekly Top Themes

  1. The Fed continues to leave the door open to options. Janet Yellen indicated "there will not be a rate hike in the next couple of meetings." All options seem to be on the table beginning with the June FOMC meeting. The Fed wants greater flexibility to raise interest rates, and economic data will become more important. Increased uncertainty should put pressure on longer-term rates.
  2. U.S. economic conditions no longer require a zero interest rate policy. The Fed should begin to normalize interest rate policy relatively soon. We anticipate the onset of policy tightening, which has not occurred in the United States in almost a decade,2 will act as a revaluation catalyst for the long end of the global yield curve.
  3. Historically, equities have performed well at the start of a rate hike cycle. Generally, equities seem to produce gains when interest rates start to creep up, then often pause for a few months before continuing to climb.1
  4. The oil price decline should be a net long-term positive for U.S. and global growth. Over time, the benefits of declining prices should make up for the near-term pullback in oil production.
  5. The bull market is nearly six years old. Investors have faced many steep walls of worry. The economy has been growing, and the stock market has been rising as a result of profits from entrepreneurial activity. We anticipate these trends will continue until corporate profits fall sharply, interest rates rise significantly or the stock market increases beyond the current value of discounted earnings.
 

The Big Picture

In the near term, significant crosscurrents lie beneath the surface. Risks are emerging, as the market appears complacent and leadership is less prominent. The market’s view of the Fed seems aligned with FOMC statements and data, and although inflation is not a concern, disinflation discussions are growing stale.

As we think about the intermediate term, we highlight key reasons to stay optimistic, as recently discussed by Potomac Research Group:

The Fed will stay accommodative Republicans can block regulatory activism
The economic recovery is improving Centrists are likely to prevail in 2016 elections
There are no shocks in Washington, D.C. The Greek crisis will get finessed
The deficit is falling The world will eventually confront ISIS
Tax reform is likely someday Israel can’t attack Iran

Assessing the environment overall, equities are hovering near the top of the range that began last fall. Reduced U.S. liquidity will force profits - which have entered a difficult phase - to become the primary driver of capital appreciation. Pricing power, rising wages and a strong U.S. dollar have dampened earnings projections. We believe the global economy is slowly healing, and low inflation allows policymakers to provide reflationary support. The extension of the Greek bailout program provides potential for the global economy to shift into higher gear by enabling the fledgling European recovery to gain traction. However, high levels of debt, geopolitical turbulence, low inflation and concerns about financial bubbles require caution. A combination of improving global growth and reflationary monetary policy underpins our pro-growth investment stance, including an overweight to equities. We believe equities will achieve positive returns in 2015, and likely outperform cash, bonds, inflation and commodities, but not without a bumpy ride.

 

1 Source: Morningstar Direct, as of 2/27/15
2 Source: Federal Reserve



 

Last Week's Commentary

Global Reflation Should Allow Equities to Push Higher


February 23, 2015
 

Key Points

  • Financial markets reacted well to the provisional Greek bailout extension, but risks for Europe remain elevated.
  • Wages appear to be starting to climb, which would increase pressure on the Fed to begin rate increases this summer.
  • There is a valid bearish case to be made, but we think the positives for equities outweigh the negatives.

U.S. equities climbed last week amid a fairly uneventful trading environment. The S&P 500 Index rose 0.7%, putting it 6.5% above the low of just a few weeks ago.1 The drama surrounding Greece’s financial woes dominated the headlines, while Walmart’s decision to boost pay for one-third of its workforce also received its share of attention. For the week, the health care sector was the best-performing, with leadership from the biotech industry, while energy companies struggled in the face of a downturn in oil prices.1

 

Weekly Top Themes

  1. The “pro-growth” investment trade remains in effect but slowed last week. Global economic data was mixed. Europe showed some improvement, but Japanese fourth quarter economic growth came in well below expectations at 2.2%.2 Bond yields were marginally higher last week, while commodity prices fell and cyclical stocks slightly outperformed defensive sectors.1 Nevertheless, U.S. stocks ended the week at another record high.1
  2. The provisional Greek debt deal is a positive, but the risks are still high. The four-month extension of the bailout program effectively served as a capitulation by the new Greek government in their stance to abandon anti-austerity measures. Greece still has much work to do, but the agreement to have its budget programs approved by the so-called “troika” of the European Central Bank, the European Commission and the International Monetary Fund reduces the risk of a messy exit by Greece from the European Union. Even assuming the provisional deal goes through, however, it only lasts for four months. The worries over Greece have only faded, not vanished completely.
  3. The eurozone economy appears to be slowly improving. Business, investor and consumer confidence have been ticking up,3 which should translate into an easing of deflation fears and better growth. Europe still faces a number of headwinds, including the need for more structural reforms. At the same time, political turmoil in Greece and Russia could cause issues for the eurozone.
  4. Modest wage increases appear to be on the horizon. Last week’s news from Walmart continues a trend of companies announcing pay increases, and we believe the government’s official wage data will soon start to reflect higher salaries for American workers. The growth in new jobs and the decline in the unemployment rate are also putting upward pressure on wages. Wage levels are one of the Federal Reserve’s key economic barometers used to judge the state of the economy, so such increases should prompt the Fed to begin normalizing interest rates. We believe this summer is the most likely timeframe for the Fed to act.
  5. When the Fed does begin to increase rates, we believe it will have a number of effects on financial markets. For the bond markets, we expect Fed action would cause short-term yields to move up while longer-term yields would move erratically higher. This would result in a flatter yield curve (known as a “bear flattener”). We also think credit spreads may widen and the U.S. dollar should rise. For equity markets, we believe a move by the Fed would increase volatility, but we would still expect equities to grind higher.
 

The Bullish Case for Equities Appears Intact

Equities are currently testing the tops of their recent trading ranges, and we think whether this is resolved by stock prices moving higher or by falling back will depend on the tug-of-war between ample global liquidity and a slight softening in corporate profits. Easy monetary policy, the drop in oil prices and the rise of the U.S. dollar have all been positive factors for the consumption-oriented U.S. economy, but they have also put downward pressure on U.S. profits.

The bulls believe global reflation and a stronger U.S. economy will help global growth and allow investors to look past the current corporate profit softness. The more bearish case is that still-lingering deflation will work its way into the U.S. economy just as the Fed is starting to raise rates. We acknowledge the downside risks, but lean more toward the bullish arguments.

 

1 Source: Morningstar Direct and Bloomberg, as of 2/20/15
2 Source: Cabinet Office of Japan
3 Source: The European Commission



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A Word on Risk
The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-investment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results. Certain information contained herein is based upon third-party sources, which we believe to be reliable, but is not guaranteed for accuracy or completeness.

Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.

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