Despite Uncertainty, Market Conditions Should Improve

Key Points

▪ Investor uncertainty and pessimism are high, but we believe the underlying fundamentals are stronger than widely perceived.

▪ Although a number of near-term risks could cause equity market choppiness, we expect prices will move unevenly higher over the next year.

A number of events drove investor behavior last week, including an announced delay in implementing a new sales tax in Japan, European Central Bank and OPEC meetings and a highly disappointing U.S. jobs report. Despite all of the activity, however, the S&P 500 Index was virtually unchanged for the week.1

Investor Unease Remains High
The near-term outlook is quite cloudy. The economic picture is unclear, especially after last week’s jobs numbers. The Brexit referendum in the U.K. is causing uncertainty. OPEC’s failure to reach consensus on production could call into question the stability of oil prices. And possible Federal Reserve rate hikes are unnerving investors. As a result, some are predicting we are at the forefront of the type of significant sell-off in risk assets we saw last August and early this year. We agree that markets will remain choppy, but believe the economy and financial conditions are more stable than the above list of concerns indicates. As such, we believe any near-term sell-offs should be brief and shallow.

Weekly Top Themes

1. Last week’s jobs numbers call into question the prospects of a June rate hike. May employment growth was exceptionally weak, with just 38,000 new jobs reported.2 Given this weakness, a rate hike in June is less likely than previously thought. The Fed could still raise rates in July or September, but that would likely require a bounce-back in jobs growth.

2. We expect second quarter economic growth to improve. Real GDP growth should be between 2% and 3% (compared to 1.4% last quarter).3 Nominal growth should rise to more than 4%, since we are seeing signs of modest inflation.

3. Global economic growth continues to diverge. Manufacturing represents a key example. U.S. PMI rose to 51.3% in May, and we expect it will trend higher.4 In contrast, Chinese PMI fell to 49.2% last month and appears to be falling.5

4. Corporate earnings should improve later this year. The twin drags of collapsing oil prices and the soaring U.S. dollar should fade over the coming quarters. First quarter earnings fell nearly 5%.6 But consensus expectations are that earnings will grow 1%, 5% and 7% in the second, third and fourth quarters, respectively.6

5. Investor negativity may not match reality. The research firm Cornerstone Macro recently said it best: “It’s not often that you can say that oil prices are up over 30% year to date, and investors are worried about deflation. It’s not often you can say that the market is [close to] an all-time high, yet investors are worried about growth. It’s not often you can say ‘risk-on’ is working and yet bullish sentiment is sitting near all-time lows. It’s not often you can say the VIX is at 13, yet investor uncertainty is at modern highs.”7 Clearly, there is a disconnect between the data and investor attitudes.

We Favor Equities, but Anticipate Choppiness
Investors are now left to wonder whether the recent increase in equity prices reflects real underlying improvements in the economy and earnings picture, or whether it is a temporary mirage. We lean more toward the former interpretation. The global economy has been resilient to shocks over the past several years and we believe it is improving. Key metrics include U.S. consumer spending, global manufacturing and global trade levels. To be sure, the global economy remains fragile and vulnerable to some sort of negative shock, but we think the odds are more likely than not that world growth should accelerate modestly.

As we discussed earlier, several near-term risks could damage equity markets. However, we think investors will grow more confident in the state of the global economy and should react positively to improvements in earnings growth over the next few quarters. There is little doubt that markets will remain choppy, and equity prices won’t move in a straight line. But one year from now, we believe equity markets will be in better shape than today, and we think stocks will outperform bonds and cash.

1 Source: Morningstar Direct, as of 6/3/16
2 Source: Bureau of Labor Statistics
3 Source: Bureau of Economic Analysis
4 Source: Institute of Supply Management
5 Caixin Media Co.
6 Source: FactSet
7 Source: Cornerstone Macro, “Portfolio Strategy,” 5/31/16

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. 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. 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. MSCI EAFE Index is a free float-adjusted market capitalization weighted index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is an unmanaged market index of U.S. Treasury securities maturing in 90 days that assumes reinvestment of all income. The VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.


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