Key Points
▪ Market sentiment has improved noticeably since the beginning of the year.
▪ Although equity markets are little changed over the past month, leadership is shifting toward economically-sensitive cyclical sectors.
▪ We believe in a pro-growth, pro-risk investment stance, but also suggest nearterm caution.
Equity markets have been trendless and little changed over the past month. Stocks drifted lower last week, with the S&P 500 Index falling 0.7%.1 The main economic event was Federal Reserve Chair Janet Yellen’s speech at Jackson Hole on Friday, where she indicated rate hikes were looking more likely.
Weekly Top Themes
1. We expect gross domestic product growth will accelerate in the third quarter. The housing market is benefiting from very low mortgage rates, rising household formation and solid jobs growth, which should boost growth. It is possible, however, that consumer spending growth could slow after a strong second quarter.
2. The odds of a Fed rate hike have risen. The most notable line from Fed Chair Yellen’s speech last week was the unambiguous, “I believe the case for an increase in the fed funds rate has strengthened in recent months.” We think December is the most likely timeframe.
3. Government spending will likely increase next year. Regardless of who wins November’s elections, the appetite for new spending measures appears to be growing. We think a new infrastructure spending deal is a high probability. There is also a chance this could be coupled with much-needed corporate tax reform around the issue of repatriated earnings.
4. The inflation outlook is becoming more uncertain. For years, inflation has been a non-factor, while economic growth levels were highly uncertain. Looking ahead, we expect questions over the level of inflation will become more prominent as it moves slowly higher.
5. U.S. equity markets appear to be undergoing a leadership change. Although broad market indices are little changed since the post-Brexit fallout, market internals have shifted. Specifically, more defensive, yield-generating sectors have faltered while economically sensitive cyclical areas have outperformed.1 We expect this trend is likely to continue, especially since it appears to us that yieldoriented segments may be overvalued.
Receding Risks Are a Positive for Equities
Market sentiment appears to have shifted notably since the beginning of the year. In early 2016, deflation fears were rampant and investors were focused on the ongoing collapse in oil prices. Today, those risks have all but vanished. Oil prices have stabilized, and positive economic momentum in the United States, China and most of Europe has reduced anxiety over a possible deflationary spiral. The Brexit issue is likely to cause a recession in the United Kingdom, but those risks appear well contained. These factors help explain the recent risk-on trend in financial markets.
Concerns over central bank policies also appear less pressing than earlier in the year. Of all the major central banks, only the U.S. Fed is on track to raise rates. But even the Fed is in no hurry to hike, despite signs of improving growth, rising wages and modestly higher inflation. Low bond yields and low policy rates throughout the world have been another equity-friendly factor as they have provided support for higher valuations.
Risks still remain, of course, but for now the most significant appear relatively contained. Political uncertainty has faded, with the U.S. elections outcome pointing to a likely continuation of divided government. The Italian referendum remains a wildcard, but as long as Europe’s banking system remains stable, we do not expect that event to cause significant financial disruption. The possibility of a spike in bond yields is also something investors need to consider, but we think the odds of that happening are low.
Together, these factors prompt us to believe in a pro-growth, pro-risk investment stance, but we are far from aggressive in this belief. We think equities should continue to perform well in either the current slow, uneven economic growth backdrop or in an environment of slightly better growth. A growth slowdown would hurt equity markets, but we do not think this is likely. The possibility of some sort of setback is relatively high, especially considering that markets have rallied around 10% since the Brexit vote.1 On balance, however, we think it is more likely than not that equity prices will trend higher over the coming year.
1 Source: Morningstar Direct, as of 8/26/16
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.
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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