Key Themes for the Fourth Quarter and 2016
October 5, 2015
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Volatility may persist as Fed policy remains uncertain.
Markets are likely to remain trendless as additional healing is needed.
Assuming the global economy improves, corporate earnings should strengthen. That’s a recipe for better equity performance.
The Global Economy Faces Risks, but Should Improve
Since the Great Recession, the global economy has grown sporadically at a below-trend
pace. This is unlikely to change in the short-term, but we expect ongoing
improvement, led by growth in the United States.
The U.S. economy continues to expand, and the major contributors to growth (the
consumer, corporate and government sectors) all appear to be in decent shape.
We expect economic conditions to continue to improve in the coming quarters.
There is a risk, however, that many have not been focusing on: deteriorating credit
conditions. The high yield market in particular has struggled, and high yield market
trends often foreshadow stock market developments.1 Specifically, we are concerned
about rising default rates in the high yield energy sector and stress from declining
profits and deteriorating free cash flow. Turmoil and tensions in emerging markets
are also problematic, since the high yield sector tends to be correlated to that asset
class.1 Overall, we think credit issues are manageable (and the easing of bank lending
standards should help), but problems in the credit market may affect the broader
economy and equity markets.
Equity Markets Should “Survive” Rate Hikes
The prospect of the first Federal Reserve interest rate hike in nearly a decade has been
one of the most debated and discussed topics this year. Although rate increase cycles
are usually accompanied by equity volatility, investors typically view the development
as a sign that the economy is improving. As such, equities have historically performed
well when rates start to rise (for details, see "Rising Rates Shouldn’t End This Bull Market.")
The current cycle is atypical, however. The Federal Reserve has waited so long to
raise rates, making valuations and profit margins higher than they usually are at the
beginning of rate increase cycles.1 This could make equity markets more vulnerable.
Rate increases may drive near-term volatility higher, but we think improved long-term
economic growth should boost earnings and equities.
Our Investment Outlook Is Moderately Constructive
The questions driving equity performance over the next six to twelve months are:
Will the global economy improve? Will corporate earnings continue to advance? We
say yes to both, and make the following points:
- Equity bear markets typically occur when the economy falls into recession and
corporate profits experience a pronounced decline. The odds of a global or U.S. recession are low, which means more upside potential than downside risk to the
- Despite recent market volatility, forward earnings expectations for U.S.
companies have held up remarkably well.2
- U.S. retail sales have been increasing,3 which should lead to improved corporate
earnings in the coming quarters.
- Earnings results from Europe and Japan will likely depend on broad global
conditions. Forward and trailing earnings estimates for both regions have been
rising,2 and should the global economy continue to improve, we think these
trends will persist.
- We expect energy sector weakness to diminish over time, but commodity-related
sectors and markets should continue to be weak spots for earnings.
The main risk to this outlook is the possibility of deteriorating U.S. or global
economic conditions, which could significantly dampen earnings expectations. We
may see some downgrades in the near term, but we think the outlook for corporate
earnings is generally positive.
As such, we continue to favor equities compared to bonds or cash. Volatility is likely
to persist and equity markets may continue to struggle until we see more clarity
around Fed policy. Over the long-term, however, we think it makes sense to adopt
overweight positions in equities, with a particular emphasis on non-resource-related,
domestic sources of revenues.
1 Source: BCA Research
2 Source: MRB Partners
3 Source: Commerce Department
Last Week's Commentary
Equities May Remain Trendless Until More Clarity Emerges
September 28, 2015
Janet Yellen’s comments last week increased the likelihood for a rate increase in 2015, which would be good news for equities.
U.S. economic growth and corporate earnings trends should both improve.
Volatility may persist for some time, but we still have a favorable view toward equities.
Sentiment was negative for most of last week, as investors focused on
continued uncertainty over Federal Reserve policy, slowing growth in China
and emerging markets and ongoing weakness in commodities. Stock prices
bounced on Friday following comments from Fed Chair Janet Yellen that a
rate increase was looking more likely in 2015. Nevertheless, equities finished
in negative territory, with the S&P 500 Index falling 1.4%.1 The health care,
materials and industrials sectors came under pressure, while utilities, consumer
staples and financials finished higher.1
Weekly Top Themes
- Second quarter growth was revised higher. Real gross domestic product growth
was revised from 3.7% to 3.9%, helped by improved retail sales figures.2 Looking
ahead, we expect sales figures will continue to drive growth higher, but we also
anticipate a drag from a drawdown in high inventory levels.
- Janet Yellen's comments increased the odds that the Fed would raise rates
later this year. Her speech last week was more clear than the statement that
accompanied the September policy meeting. The Fed Chair cited a reasonably
solid economy and an improving labor market as reasons to justify a rate increase.
She also pointed out that inflation remains below target, but indicated that global
pressures may be transitory.
- For U.S. corporations, domestic profits should continue to outpace non-U.S.
profits. At present, U.S. domestic corporate profits are approximately two-and-a-
half times higher than non-U.S. profits.3 If the U.S. economy can remain
relatively decoupled from the rest of the world, we expect this trend will persist.
- The near-term direction of equity markets looks uncertain. Following the
sharp pullback in August, markets appear to be trying to form a base. We expect
that the next significant trend in equities will depend on economic growth and
earnings results in 2016. At present, indications for both are murky.
- Active managers have become less correlated to the broader market, which
could be a bullish signal. Recently, the beta for hedge funds has fallen and is
now close to zero, while the beta for actively managed mutual funds is 0.85, both
three-year lows.4 These beta levels have has fallen sharply over the last month,4
which may indicate opportunities for equities to move higher when fundamental
conditions look more certain.
We Still Favor Equities over the Long Term
U.S. equities are likely to struggle until it becomes more clear that China’s economy
will stabilize and the Fed will start lifting rates. The good news is that we expect
both of these to happen, but another risk lies on the horizon. The possibility of
another U.S. government shutdown looms, and John Boehner's decision to resign
likely increases the odds of a standoff over government spending. The current
continuing resolution should keep the government funded through December 11,
when the debt ceiling will need to be raised. This is an issue that could drive market
For now, the main focus for investors continues to be Fed policy. We think we’ll
need to see clear indications from the Fed that it will begin moving rates higher for
equities to sustain a rally. The delay in starting an increase cycle acts as a headwind
for equities since it potentially fuels price imbalances, exacerbates the possibility of
asset price bubbles, increases uncertainty and could force the Fed into tightening at
a faster pace than it wants to. Ultimately, a risk-averse Federal Reserve attuned to
promoting economic growth should be a positive for risk assets, including stocks. In
the near-term, however, the delay and uncertainty is keeping equity prices in check
and is putting downward pressure on bond yields.
Financial markets may remain choppy for some time, but we expect investors
will eventually return to focusing on fundamentals, which should benefit equities.
We believe the global economy should continue to grow unevenly and corporate
earnings should improve. As a result, we continue to favor equities over bonds and
cash. We also have a particularly positive view toward cyclical equity sectors and
markets that are not tied to commodities.
1 Source: Morningstar Direct, as of 9/25/15
2 Source: Commerce Department
3 Source: Cornerstone Macro
4 Source: FundStrat Global Advisors. Beta is a measure of the variability of the change in the share price for a fund in relation to a change in the value of the market. Funds with betas higher than 1.0 have been, and are expected to be, more volatile than the market; funds with betas lower than 1.0 have been, and are expected to be, less volatile than the market.