The Calm Before the….

Key Points

  • A period of peace has reigned in the market over the past month, but the lull in volatility likely won’t last. However, we do believe the secular bull market has further to run.
  • The third quarter is shaping up to improve on lackluster first half US economic results but weak corporate confidence remains an impediment to stronger growth. Federal Reserve policy uncertainty is likely to heat up heading toward the September Federal Open Market Committee (FOMC) meeting.
  • In contrast to the developed world, emerging markets (Ems) have had an active summer. There are good reasons behind the surge, but it may not last.

Market calm unlikely to last—be prepared

Volatility has fallen to near multi-year lows amid the traditionally slow summer vacation season,, Congress is out of session, and much of Europe is on vacation as well But traders will come back to work, politicians and central bankers will return to problems which haven’t gone away, and market action and volume should both ramp up.

Volatility low…for now

Source: FactSet, Chicago Board of Trade. As of Aug. 16, 2016.

We remain neutral on U.S. equities, which means we recommend investors remain at their long-term target equity allocations, while using volatility to tactically rebalance around those levels. We believe the current bull market will continue but not without some additional drama. The nice thing about the past month is that it has allowed investors and policy makers alike to catch their breath following the chaos that followed the Brexit vote. The sharp selloff was followed by a steep rebound and move to new record highs for major indices. Investor sentiment had moved into excessive optimism territory, according to the Ned Davis Daily Trading Sentiment Composite, but it’s since pulled back toward neutral territory. And longer term sentiment remains relatively pessimistic, despite the move to new record highs. Investors pulled another $6 billion out of U.S. equity mutual funds and exchange-traded funds (ETFs) last week, bringing the year-to-date total to $95 billion, according to ISI Evercore Research—close to record outflows. This continued doubt among investors makes us feel more comfortable with our mildly bullish view—remember, investor sentiment tends to work in a contrarian fashion.

Steady improvement in economy

The latest batch of U.S. economic data doesn’t appear to presage an imminent recession, which would typically lead to a bear market. Consumer confidence has firmed, with the labor market continuing to improve, housing looking good, and wages finally starting to rise. Additionally, we’ve seen both revolving consumer credit and bank loans increase, indicating consumers may be more comfortable taking on debt.

Rising revolving credit

Source: FactSet, Federal Reserve. As of Aug. 16, 2016.

And higher bank loans indicate improving consumer confidence.

Source: FactSet, Federal Reserve. As of Aug. 16, 2016.

Unfortunately, business confidence remains subdued, reflected in weak productivity.

Productivity continues to decline

Source: FactSet, U. S. Dept. of Labor. As of Aug. 16, 2016.

It will be difficult to get the U.S. economy rolling without an improvement in productivity. A contributing factor to weak productivity is undoubtedly ongoing tepid capital spending . The National Federation of Independent Business (NFIB) recently reported that small business optimism ticked only slightly higher to a still relatively lackluster level of 94.6. For context, from 2000-2006, this reading spent much of its time at or above the 100 mark. Additionally, industrial production has been relatively weak, but there is some hope as gains have been posted in the past two months.

Industrial production weak but showing glimmers of improvement

Source: FactSet, Federal Reserve. As of Aug. 16, 2016.

Policy makers at a loss?

Both monetary and fiscal policy makers appear at a loss as to how to grease the economy’s gears. Employment remains strong, and wages have been rising, but spending on productivity- and efficiency-enhancing equipment remains quite weak. We also believe that low, and even negative interest rate policies globally, may be having the opposite of the intended affect. The Wall Street Journal recently showed that consumer savings rates in countries with negative interest rates have actually risen. We could be seeing the same thing among U.S. businesses, with low interest rates being used to pay off debt, buy back shares, or bolster cash reserves… but not invest in broader growth producing initiatives.

It’s been a hot summer for emerging markets

In contrast to the sleep action of much of the developed world, this summer has been especially hot for EM stocks, after underperforming developed markets in 2015 and getting off to a cold start in 2016. As of mid-May the MSCI EM Index was flat for 2016, but has since posted an 18% gain for the year through August 16, relative to just 6% for developed market stocks tracked by the MSCI World Index.

The EM rally has been driven by improving economic growth. The disparity in economic growth momentum between EMs and developed markets, measured by their respective composite purchasing managers indexes (PMI), has narrowed to zero, after several years of emerging markets lagging developed markets. The same is true for relative stock market performance, as you can see in the chart below.

Emerging markets have closed the gap with developed markets on growth and performance

Source: Charles Schwab, Bloomberg data as of 8/17/2016.

The improved growth momentum is helping lift analysts’ earnings per share expectations for EM stocks, as you can see in the chart below. The rise of about 8% in the dollar amount of earnings per share from the late-February low is double the 4% increase seen for developed market stocks.

Analysts’ earnings expectations for EM stocks are on the rise

Source: Charles Schwab, Factset data as of 8/17/2016.

It isn’t just the outlook for earnings that is lifting EM stocks; valuations are also on the rise. The risk of a hard landing in China has been the center of concern among EM stocks for years, but the increase in China’s PMI and corresponding fall in China’s credit default swaps (a market-based measure of the potential for a crisis in China) is lowering investors’ perception of risk and supporting price-to-earnings ratios.

Market participants’ perception of risk in China is falling as economy stabilizes

Source: Charles Schwab, Bloomberg data as of 8/17/2016.

However, extending EM outperformance beyond the summer faces a number of challenges. Aside from the potential for tighter global financial conditions and fading optimism on the strength of recoveries in Brazil and Russia, the rebounding growth momentum in China may soon begin to fade. Much of the fear that weighed on EM performance last year was derived from the risk of a sharp economic slowdown, or “hard landing,” in China. After China’s manufacturing PMI in 2015 hit the lowest levels since the 2008-2009 global financial crisis, it rebounded to near the highs of the five-year range. This suggests that the momentum that has lifted EM stocks may soon begin to fade, as you can see in the chart below.

China’s manufacturing rebound may slow and provide less lift to emerging market stocks

Source: Charles Schwab, Bloomberg data as of 8/17/2016.

RM stocks’ hot streak may cool with the temperatures this fall. But investors who have benefitted from exposure to EM stocks this year don’t need to freeze them out of their portfolios. Rebalancing exposure back to a long-term target allocation may be the best approach.

So what?

The summer lull shouldn’t allow complacency to set in. We expect the U.S. bull market to continue, but risks remain and volatility is likely to pick up. But with a solid U.S. consumer, and modestly improving economic and earnings growth, we think the general equity trend will be higher. Although EM stocks have had solid summer gains, we caution investors against chasing returns and to rebalance as needed.

© Charles Schwab

© Charles Schwab

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