Market Unease May Continue for Some Time

Key Points

• Investor sentiment remains depressed, and volatility in equities is likely to persist.
• We think concerns over Fed policy are overstated and that investors should not fear higher rates.
• Economic fundamentals remain solid, which should eventually help earnings and equity prices improve.

Markets calmed last week relative to recent turmoil, but investor sentiment remains fragile. The focus on Federal Reserve policy, weakness in China and concerns about economic growth continued to drive sentiment. The S&P 500 Index gained 2.1%, commodities were flat and bond yields rose.¹ Technology and health care posted the best results, while energy lagged.¹

A Rate Hike Shouldn’t Derail the Economy or Equities

The timing of Fed rate increases and how they may affect the markets have become the most heavily-debated topics this year. On one hand, the chief economist at the World Bank claimed a rate hike could trigger a financial shock and a crisis in emerging markets. On the other hand, optimists believe a rate hike would be a positive for risk assets since it could remove a major overhang on sentiment. There is also a sense that the Fed needs to act soon to maintain its credibility.

Regardless of whether or not the Fed increases rates this week or not, investors seem nervous about the implications. Our view is that economic fundamentals are strong enough to warrant higher rates. The start of a rate increase cycle could prove to be a non-event from an economic and markets perspective, provided it is communicated clearly by the Fed.

Weekly Top Themes

1. China is encountering weakness on a number of fronts. Corporate profits are weakening, which is slowing employment.² Rising inventories have the potential to further slow production and intensify capital outflows despite policy easing.²
2. The slowdown in China and emerging markets should have a limited effect on the U.S. economy. Corporate profits of larger companies, represented by the S&P 500 Index, are likely to come under pressure. Total employment in the S&P 500 companies, however, represents only 17% of overall U.S. employment.³ As such, we could see downward pressure on corporate profits without it having broader economic ramifications.
3. The current sell-off in equities seems to have damaged investor confidence more than previous downturns have. A number of factors are putting downward pressure on sentiment despite signs that U.S. economic growth remains solid. The narrative surrounding China has shifted from one of consistent and strong growth to one where policymakers are confusing investors. Additionally, the pending start of a rate hike cycle has been unnerving to many. A maturing economic expansion and equity bull market are also causing some to question how long they can last.
4. Equity markets may need more time to heal. We think markets appear oversold, but the fact that equities have been unable to sustain rallies so far suggests that volatility and downward pressure could remain with us.

Volatility Should Persist, but Fundamentals Remain Sound

From the beginning of this year through August, equity markets trended sideways before investors panicked over mounting weakness in China. Earnings headwinds related to falling oil prices and the stronger dollar, as well as angst over Fed policy, contributed to the negativity.

Investors have been on edge since the end of the Great Recession, but we think underlying economic trends are much stronger than are widely perceived. One of the most important U.S. leading economic indicators provided some good news last week: Fourth-quarter hiring plans stayed strong in the small business sector, and hit their highest level since 2007 for large companies.⁴ This performance is particularly impressive given the softness in profits so far this year.

We expect some measure of calm for the financial markets will develop, but it will take some time. Eventually, we think investors will become less pessimistic about China, and will acknowledge improving growth in the United States and Europe. Additionally, we think it will help when the Fed finally does raise rates and it becomes clear that higher rates are not going to derail the expansion. We continue to hold a "pro-growth" investment view, and believe it may make sense for investors with long-term time horizons to add to equity positions on market weakness.

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