Is Slowly Improving
August 29, 2016
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Market sentiment has improved noticeably since the beginning of the year.
Although equity markets are little changed over the past month, leadership is shifting toward economically-sensitive cyclical sectors.
We believe in a pro-growth, pro-risk investment stance, but also suggest near-term caution.
Equity markets have been trendless and little changed over the past month. Stocks drifted lower last week, with the S&P 500 Index falling 0.7%.1 The main economic event was Federal Reserve Chair Janet Yellen’s speech at Jackson Hole on Friday, where she indicated rate hikes were looking more likely.
Weekly Top Themes
- We expect gross domestic product growth will accelerate in the third quarter. The housing market is benefiting from very low mortgage rates, rising household formation and solid jobs growth, which should boost growth. It is possible, however, that consumer spending growth could slow after a strong second quarter.
- The odds of a Fed rate hike have risen. The most notable line from Fed Chair Yellen’s speech last week was the unambiguous, “I believe the case for an increase in the fed funds rate has strengthened in recent months.” We think December is the most likely timeframe.
- Government spending will likely increase next year. Regardless of who wins November’s elections, the appetite for new spending measures appears to be growing. We think a new infrastructure spending deal is a high probability. There is also a chance this could be coupled with much-needed corporate tax reform around the issue of repatriated earnings.
- The inflation outlook is becoming more uncertain. For years, inflation has been a non-factor, while economic growth levels were highly uncertain. Looking ahead, we expect questions over the level of inflation will become more prominent as it moves slowly higher.
- U.S. equity markets appear to be undergoing a leadership change. Although broad market indices are little changed since the post-Brexit fallout, market internals have shifted. Specifically, more defensive, yield-generating sectors have faltered while economically sensitive cyclical areas have outperformed.1 We expect this trend is likely to continue, especially since it appears to us that yield-oriented segments may be overvalued.
Receding Risks Are a Positive for Equities
Market sentiment appears to have shifted notably since the beginning of the year. In early 2016, deflation fears were rampant and investors were focused on the ongoing collapse in oil prices. Today, those risks have all but vanished. Oil prices have stabilized, and positive economic momentum in the United States, China and most of Europe has reduced anxiety over a possible deflationary spiral. The Brexit issue is likely to cause a recession in the United Kingdom, but those risks appear well contained. These factors help explain the recent risk-on trend in financial markets.
Concerns over central bank policies also appear less pressing than earlier in the year. Of all the major central banks, only the U.S. Fed is on track to raise rates. But even the Fed is in no hurry to hike, despite signs of improving growth, rising wages and modestly higher inflation. Low bond yields and low policy rates throughout the world have been another equity-friendly factor as they have provided support for higher valuations.
Risks still remain, of course, but for now the most significant appear relatively contained. Political uncertainty has faded, with the U.S. elections outcome pointing to a likely continuation of divided government. The Italian referendum remains a wildcard, but as long as Europe’s banking system remains stable, we do not expect that event to cause significant financial disruption. The possibility of a spike in bond yields is also something investors need to consider, but we think the odds of that happening are low.
Together, these factors prompt us to believe in a pro-growth, pro-risk investment stance, but we are far from aggressive in this belief. We think equities should continue to perform well in either the current slow, uneven economic growth backdrop or in an environment of slightly better growth. A growth slowdown would hurt equity markets, but we do not think this is likely. The possibility of some sort of setback is relatively high, especially considering that markets have rallied around 10% since the Brexit vote.1 On balance, however, we think it is more likely than not that equity prices will trend higher over the coming year.
1 Source: Morningstar Direct, as of 8/26/16
Last Week's Commentary
The Bullish Case Is More
Compelling Than the Bearish
August 22, 2016
Following a strong post-Brexit rally, equity prices have stabilized in recent weeks.
A number of positive factors could push prices higher, but these are balanced by several risks.
On balance, we think the positives outweigh the negatives, but caution that markets are likely to remain uneven.
Most financial market developments occurred outside of equity markets last week. The U.S. dollar came under pressure following a generally dovish tone from the July Federal Reserve policy meeting minutes. Oil prices continued to advance amid ongoing speculation about production cuts. U.S. equities were up modestly last week, with cyclical areas such as banks, semi-conductors, autos, materials and energy leading the way.1 Real estate, telecommunications, drug companies and utilities lagged.1
Weekly Top Themes
- U.S. manufacturing activity is likely to accelerate. Retail sales have been solid and manufacturing inventories have been declining.2 This combination suggests a modest pickup in manufacturing in the third quarter.
- We expect a Fed rate hike later this year. A September increase is a possibility, but unlikely. We think December is a better bet.
- It is hard to see how the United Kingdom will avoid a recession. The post-Brexit rules could take years to be finalized, creating ongoing uncertainty for businesses. The silver lining is that Brexit effects remain contained, meaning that a UK recession will not necessarily expand to the eurozone.
- Low bond yields remain supportive of equity prices. While we expect upward pressure on bond yields due to improving economic growth, the Fed and other central banks remain acutely attuned to keeping financial conditions stable and are unlikely to tighten policy quickly or dramatically. As such, bond yields are unlikely to increase sharply.
- It will be difficult, however, for equity prices to advance without additional support. Equity indices have again hit new records, but we believe fundamental changes may be necessary for prices to continue advancing strongly. Specifically, earnings would have to improve further and/or investor flows would have to turn notably toward stocks. Neither is out of the question, but aren’t likely.
The Back-and-Forth in Stocks Will Likely Persist
Since the initial fallout from the Brexit vote, U.S. stocks experienced a strong rally
and have been trading sideways and marginally higher. This sparked the all-too-
familiar bull versus bear debate, leading us to list the positive and negative factors for
Reasons to be positive:
- If yields remain low, equity valuations should have room to advance.
- Earnings have been improving modestly and forward guidance has been solid.
- Global policymakers have been hinting at fiscal stimulus and we expect increased spending in the U.S. regardless of the outcome of November’s elections.
- The U.S. political outlook is becoming clearer, and it appears our government will continue to be divided (which isn’t necessarily bad for financial markets).
- The global banking system remains reasonably healthy thanks to decent balance sheets.
- Brexit-related risks appear contained.
- U.S. economic growth is reasonably solid and the global economy appears on track, outside of the UK.
- Oil prices have stabilized and have become less of a factor driving equity markets.
- Chinese currency risks have diminished as price depreciation has been steady and even.
- Bipartisan support for corporate tax reform appears to be growing and could occur in 2017.
Reasons to be cautious:
- Global government bond yields appear artificially low and a possible spike could disrupt financial markets.
- Central banks have exhausted their policy options and have little ability to respond to any new crises.
- Financial markets appear overly complacent about the prospects for Fed rate hikes.
- Expectations for future corporate earnings may be too high.
- Additional fiscal stimulus and a lack of monetary policy options could put upward pressure on global bond yields.
- Several months remain before the U.S. elections, and uncertainty levels could rise again.
- Geopolitical uncertainty and terrorism risks (especially of the lone wolf variety) remain high.
On balance, we think the positives will outweigh the negatives, but the frustrating, back-and-forth in stock prices we have seen all year is likely to persist.
1 Source: Morningstar Direct, as of 8/19/16
2 Source: Commerce Department