Key Points
▪ 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:
1. Equity bear markets typically occur when the economy falls into recession and corporate profits experience a pronounced decline. The odds of a global or recession are low, which means more upside potential than downside risk to the earnings outlook.
2. Despite recent market volatility, forward earnings expectations for U.S. companies have held up remarkably well.2
3. U.S. retail sales have been increasing,3 which should lead to improved corporate earnings in the coming quarters.
4. 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.
5. 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
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Euro STOXX 50 Index is Europe’s leading Blue-chip index for the Eurozone and covers 50 stocks from 12 Eurozone countries. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. FTSE MIB Index is an index of the 40 most liquid and capitalized stocks listed on the Borsa Italiana. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The MSCI World Index ex-U.S. is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets minus the United States. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
RISKS AND OTHER IMPORTANT CONSIDERATIONS
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. Noninvestment-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.
Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.
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