• 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 near-term 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 yield-oriented 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
Bob Doll is chief equity strategist at Nuveen Asset Management.