▪ Equity prices have taken a breather following a strong post-Brexit rally.
▪ Technical conditions suggest the equity market is strengthening and selectivity is becoming more important.
▪ If corporate earnings continue improving, we believe the rally should endure.
Equity markets digested a great deal of information last week. Corporate earnings continued to improve (particularly in the technology sector) and the U.S. dollar and oil prices declined. The Federal Reserve acknowledged financial risks have been diminishing, as the economy appeared to stabilize. Finally, second-quarter gross domestic product growth was reported to be weaker than anticipated. Despite all of the news, however, prices were little changed and the S&P 500 Index was essentially flat for the week.1
Weekly Top Themes
1. Second quarter growth was weak, but consumer spending advanced. GDP expanded at only 1.2% for the quarter, well below expectations.2 Inventories represented the biggest drag and business investment was soft.2 However, consumer spending climbed 4.2% during the quarter.2
2. The Fed appears to be starting to prepare markets for another rate hike. The Fed’s comments last week were more upbeat than previous statements. We do not expect an imminent rate hike, but we believe the Fed could raise rates in December.
3. Oil prices will likely remain under pressure. Oil has softened in recent weeks due to rising inventories and persistent oversupply. We expect these trends will continue and believe oil prices will remain in the $30 to $60 range for several years to come.
4. Evolving market leadership points to signs of optimism. Equity markets are little changed over the past few weeks, but internal market dynamics have shifted. Cyclical and more economically sensitive sectors have outperformed defensive, lower-volatility and higher yielding sectors.3 We believe this indicates investors are expecting better economic and earnings growth.
5. Technical signs for equity markets are also turning positive. In addition to these sector changes, the equal-weighted S&P 500 Index has outperformed the market-weighted index since the post-Brexit rally began.4 This means the average stock has outperformed the broader market. We think this is positive for future prices and argues for careful selectivity and active management.
Corporate Earnings and Profits Could Improve
U.S. equity prices are near record highs, and we believe technical conditions remain supportive for stocks. Despite the weak second quarter GDP report, we believe the economy is continuing its slow-growth pace, which should help equity markets. Corporate earnings have also turned in a positive direction. The recent slide in oil prices represents a potential risk as investors remain wary of another sharp downturn that could again act as a headwind for stock prices. Yet we believe that if oil remains range-bound, equities should not see significant contagion. Prospects for non-U.S. markets appear less rosy, however. Brexit-related worries may continue to plague Europe, and global economic growth remains challenged.
While equity markets have rallied strongly following the Brexit vote, government bond yields remain close to record lows despite signs of economic resilience. In our view, low yields are a reflection of lingering economic pessimism and a belief that central banks are primed to remain highly accommodative. The Fed has certainly indicated that it will remain cautious as regards its next rate hike and is highly attuned to both economic and financial market conditions. These factors are likely to keep bond yields from rising quickly or significantly.
Looking ahead, we believe corporate earnings remains the key variable that is needed to sustain the equity rally. The profits picture is slowly brightening, but it is too early to say that profits and earnings are on a clear upward trajectory. Nevertheless, we think a combination of a slowly growing economy, modestly improving profits and persistently low bond yields should provide a tailwind for U.S. equity prices. While valuations for stocks are not as compelling as they once were, we believe equities still look more attractive than bonds or cash.
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1 Source: Morningstar Direct, as of 7/29/16
2 Source: Bureau of Economic Analysis
3 Source: J.P. Morgan
4 Source: Strategas
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.
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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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