Equities May Struggle, but Should Outperform Other Asset Classes
Key Points
▪ Corporate earnings remain the key for equity prices. If earnings and profits improve over the coming months, equities should break out to the upside.
▪ The Brexit vote and the U.S. elections are causing an unusual amount of political uncertainty, but shouldn’t derail the markets.
Last week started on a horrific note with the massacre in Orlando. That event and growing anxiety over the possible U.K. exit from the European Union (the Brexit) dragged down investor sentiment. The S&P 500 Index fell 1.1% last week.1 Financials came under pressure, while the more defensive telecom and utilities sectors bucked the broader trend and gained ground. Non-U.S. stocks fared even worse, with European markets declining around 2% and Japanese stocks dropping over 3%.1
Weekly Top Themes
1. A Federal Reserve rate hike in July is unlikely. The decision to keep rates on hold came as no surprise, as the Fed pointed to recent labor market weakness and escalating global risks. If the June jobs report shows a strong rebound and the Brexit risk is avoided, the odds of a rate hike next month would rise.
2. The solid retail sales report from May should allay fears of a weakening economy. Sales rose 0.5% last month,2 which should provide some comfort to those who feared May’s weak jobs report was the start of a broader economic downturn. We believe that real gross domestic product may grow by as much as 3% in the second quarter.
3. The manufacturing sector, however, continues to struggle. The latest data from May shows industrial production fell 0.4%.3
4. Inflation continues to rise slowly. The headline consumer price index increased by a modest 1.0% annual rate in May.4 However, core inflation ticked up to 2.2%, the seventh consecutive month in which core inflation rose by 2% or more.4 We expect firmer commodities prices and the fading strength of the dollar should push inflation modestly higher over the coming months.
5. Still-low rates are a positive for equities, but earnings remain the key variable. Investors were cheered last week by indications that the Fed is in no hurry to raise interest rates. Looking ahead, we think the key factor that will drive equity prices is whether corporate earnings and profits can improve over the second half of 2016 and into 2017.
6. Global deflationary forces have faded, but have not vanished. Early in the year, weak commodity prices and worries over Chinese growth were triggering widespread deflation concerns. Deflation risks have receded, but remain. A steepening in global yield curves would be a key signal that deflation risks are finally in the rearview mirror.
7. Prospects for equities are mixed, but appear stronger than other asset classes. After appreciating significantly since 2009, equities are not as cheap as they used to be, but we believe they are also not in bubble territory. We think gains will be tough to come by in a slow-growth world, but we still think equities will outperform bonds and cash over the next six to twelve months. As such, we think investors should retain a pro-growth investment bias.
U.K. and U.S. Politics Are Causing Near-Term Uncertainty
The most pressing political risk is the Brexit threat. We think the odds favor the June 23 referendum not passing, keeping the U.K. in the European Union. But there is a real chance that the U.K. will choose to leave. The uncertainty has undermined economic confidence and has been a headwind for global stock markets. Should the Brexit happen, we think it would be a serious misstep that could not be easily remedied. We believe it would cause the U.K. economy to shrink and could spark housing and credit crises. A Brexit could also morph into a more widespread global financial problem as it drags down global trade levels.
The next political issue on the horizon is the uncertainty surrounding the U.S. elections. Whether or not investors like Hillary Clinton, her economic policies are clear and transparent, and come with a measure of certainty. The same cannot be said about Donald Trump, since his views are inconsistent and lacking specificity (at least as of now, and he does have five months to amplify and clarify his proposals). His most clearly articulated views indicate he may trigger trade wars, which would likely be negatives for the U.S. and global economies. From those perspectives, at least, we think equity markets would currently favor a Clinton victory.
1 Source: Morningstar Direct, and Bloomberg as of 6/17/16
2 Source: Commerce Department
3 Source: Federal Reserve
4 Source: Labor Department
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.
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.
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