We continue to believe the U.S. stock market is in a reset period, as investors contemplate the prospect of slowing global economic growth, mixed messages from the Fed (potential tightening) and the continued easing from other central banks (Japan, China and the ECB). Market participants seem concerned about the central banks’ inability to manufacture inflation after several years of near-zero interest rates. These concerns have resulted in higher volatility, catching many investors off guard.
While recent job growth data has fallen short of expectations, our view is that the U.S. can still continue on its slow growth course through 2015. (For more on our economic outlook, you can view a recent interview I had with Maria Bartiromo last week.) Although corporate earnings estimates have come down and commodity overcapacity will create pockets of weakness, other favorable factors should result in moderate growth. Most notably, positive job growth over the longer term, low interest rates, and low energy prices are contributing to strong U.S. consumer activity. Also, a slowly expanding global economy can further support the U.S.
We expect elevated volatility to persist over the next several quarters, due to both well-entrenched concerns as well as growing uncertainty around fiscal policy and the 2016 election. The recent biotech sell-off provides one example of how the election may influence the markets, as presidential candidates’ comments regarding drug pricing fueled a correction, despite elections being over a year away.
Although markets have been unnerved by the Fed’s recent comments and a policy misstep cannot be ruled out, we do not believe a move to tighten monetary policy will upend the economy or the markets over the longer term. Regardless of the timing of the first Fed rate increase, we expect the path will be slow and shallow. A more normal rate environment should ultimately prove beneficial, so long as the economy continues to improve. For example, banks can earn more from their lending activities, providing a greater incentive to loan money to small businesses, a vital engine of job growth. Also, stocks have tended to perform well after rate hikes.
In an environment of more muted economic growth where earnings growth is more scarce, we believe growth equities remain more attractive than value stocks. Given this economic environment and the market’s risk-on, risk-off dynamic, our overall stance reflects caution. Still, we expect market volatility can provide opportunities for our longer-term approach.
In addition to seeking out reasonable valuations, we are favoring companies with higher quality attributes and the ability to grow earnings even in a slow-growth economic environment. We see opportunities among companies tied to the U.S. consumer, social media and internet security, while remaining concerned about companies that are dependent on commodity prices and emerging market demand.
We maintain a highly constructive outlook for convertible securities. Because they have fixed income characteristics and equity attributes, they are often more resilient during periods of short-term market volatility, while demonstrating reduced sensitivity to interest rate increases. We believe the high volatility we’ve seen—and the probability it will continue—underscore the value of using convertibles to pursue risk-managed equity exposure.