Global Reflation Should Allow Equities to Push Higher
February 23, 2015
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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
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
- 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
- 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.
- 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.
- 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
- 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
Last Week's Commentary
Investor Sentiment Is Strengthening
February 17, 2015
Easing geopolitical issues and stabilizing oil prices are helping markets move past recent weakness.
Deflationary fears are receding, which should put upward pressure on bond yields.
We expect global equity markets will make further gains in the coming months as the world economy improves.
U.S. equities finished higher for a second straight week, with the S&P 500
Index gaining 2.1% as it ended the week at a record high.1 Investors largely
shrugged off disappointing retail sales figures and chose to focus on
the positives. Sentiment improved as a result of signs of a potential debt
restructuring deal between Greece and the European Union as well as from a
cease fire agreement in Eastern Ukraine. An additional climb in oil prices also
helped boost equity markets. The technology sector was the best-performing
area of the market last week, while utilities was the only sector that posted
Weekly Top Themes
- We expect the consumer sector to exhibit strength in 2015. Employment gains
in manufacturing, construction and in state and local governments appear to be
on the horizon. Also, low interest rates and lower energy prices should prompt
consumers to pick up spending as the year progresses. We anticipate disposable
personal income levels will accelerate in the coming months.
- For now, weak retail sales figures show that consumers are still exercising
caution. January sales were down a disappointing 0.8% last month,2 although
that figure may be skewed by a drop in spending at gas stations.
- It appears that a Greek debt restructuring deal may be on the horizon.
Nothing has been settled yet, but the Greek government and the European
Union do appear to be approaching a compromise. Any such deal is likely going
to require Greece to give up on its demands for a significant reduction in its debt
obligations in exchange for the country being allowed to run a smaller primary
- Non-U.S. growth continues to struggle. We have been seeing some signs of
improvement in European growth, but Chinese economic growth seems to be
weakening, Russian GDP growth is plummeting and Brazil may be moving into
- It is possible progress could be made in trade legislation. When it comes to
most issues, Washington appears to be mired in gridlock, but if there is one area
where we may see some legislative progress, we would expect it to be trade policy.
We Expect Equity Prices and Bond Yields to Climb
Since the end of January, global financial markets have started to stabilize. Although
deflation worries and geopolitical risks are likely to keep volatility relatively elevated,
we think there are some important factors that should provide ongoing support for
equity markets. In particular, U.S. economic acceleration should act as a tailwind for
the rest of the world, and global monetary policy remains extremely supportive.
The U.S. economic picture has brightened over the past year, and it seems obvious
to us that the United States no longer needs the extraordinarily low interest rates
the Fed adopted as part of its emergency measures during the height of the financial
crisis. Regarding global monetary policy, several central banks are still in the early
stages on their easing programs, which should help keep global financial liquidity
ample when the Federal Reserve does begin interest rate increases. Financial market
volatility is likely to increase when those rate hikes do begin, but we do not think
this event will be enough to derail the bull market.
The months-long collapse in oil prices last year and into early 2015 resulted in a
spike in deflation fears, which, in turn, caused bond yields to fall. Our view is that
lower oil prices are, in the long term, a reflationary rather than a deflationary force.
As a result, we expect yields will rebound in the coming months, which is one reason
we believe equity markets look more attractive than bond markets. Thanks to an
improving economy and still-solid earnings, the prospects for U.S. equities appear
solid to us.
Outside of the United States, the outlook for equities is a bit more mixed, but global
equity valuations still appear attractive and recent market strength in some troubled
regions such as Europe may be a positive sign for the future. As global economic
growth improves over the coming year, we believe both global equity prices and
global bond yields should rise.
1 Source: Morningstar Direct, as of 2/13/15
2 Source: Department of Commerce