Key Points

  • Bouts of market volatility are likely to persist.
  • Valuations are slightly elevated, so earnings growth likely needs to pick up.
  • The pessimism of investors remains a positive support for stocks longer term.

Stocks Grapple With Brexit

Market expectations are that The Federal Reserve is unlikely to raise rates this year in light of weak growth and the deteriorating financial conditions associated with Britain’s vote to leave the European Union, known as Brexit.  We expect the U.S. economy and stock market to continue producing mixed results. One silver lining is that sluggish growth has kept interest rates low and inflation at bay.

Stock market valuations are slightly elevated, while earnings growth remains weak.  The aftermath of Brexit, along with the highly contentious presidential election, are likely to bring continued bouts of volatility and uncertainty.  But to us this uncertainty and pessimism of investors represents the most compelling support for stock prices longer term in terms of sentiment.

Volatility—recently and prospectively—has been partly a function of Fed policy uncertainty as it relates to the “loop” in which financial conditions have been over the past year or so (as shown in the graphic below).

Driven largely by the direction of the U.S. dollar, financial conditions have been waffling between easy and tight. This in turn has kept the Fed moving between a “hawkish” and “dovish” stance.  The Brexit-related hit to financial conditions supports a more dovish Fed and suggests a continuation of the frustrating range-bound and volatile stock market behavior.

The U.S. economy continues to move like a SLUG—with Slow, Lumbering, Unstable Growth.  Every time it seems to take two steps forward, it falters. This phenomenon is not new.  There has been a meaningful slowdown in growth every year since the economic expansion began in June 2009, including this year.

In a narrow range

In a couple of those years, recession risk appeared elevated.  Yet the U.S. stock market has had an incredible run, with a total return of about 250% in the S&P 500 Index from the March 2009 low through the close on the ugly market day after the Brexit decision. That said, during the past two years, U.S. stocks have traded in a remarkably narrow range.  In the near term, we expect more of the same, with volatility.
A sluggish pace of economic growth, accompanied by low interest rates and low inflation, is not an unfavorable backdrop for equities longer-term. This is why we don’t believe a major bear market is likely…remember, the tortoise beats the hare in Aesop’s fable.

However, slightly elevated valuations, the earnings contraction, and uncertainty/volatility associated with Federal Reserve policy—and more recently Brexit and the presidential election—represent the rationale for our continued “neutral” rating on U.S. stocks. By “neutral” we mean that investors should remain at their strategic equity allocations while taking advantage of bouts of volatility to consider tactical rebalancing of their portfolios.