Key Points
• The negative feedback loop that dominated financial markets earlier this year has faded and reversed.
• There are a number of potential downside risks for equities, but we expect the positive factors will win out over time.
Market Trends Have Reversed for the Better
Early in 2016, financial markets were dominated by a negative feedback loop. Chinese economic conditions were deteriorating, which drove fears of global deflation. Oil prices fell as a result, which put downward pressure on credit markets, the banking system and the broader global economy. Those trends have recently started to reverse. Confidence in the global economy is growing, oil prices are rising and stabilizing, worries about Chinese currency devaluation are receding and credit markets appear healthier.
Global financial markets now appear in better condition than they did a few months ago. U.S. stock prices are approaching their cyclical highs and credit spreads have been narrowing.1 Investors remain jittery, however, and are focused on a number of near-term risks, including Federal Reserve policy, uncertain earnings and an unstable geopolitical backdrop.
Key Variables for Financial Markets
So what are the factors that are likely to determine the future direction of markets? We point to the following key variables:
1. The Global Economy: The world has proven to be quite resilient to shocks over the past few years, and we expect growth to improve modestly this next year. Should global manufacturing improve (and we expect it will), it would go a long way toward promoting better growth.
2. China: Authorities face a difficult task as they need to rebalance their economy while promoting growth. The stronger U.S. dollar is pressuring the Chinese economy, but we do not anticipate a hard landing.
3. The Federal Reserve: Given the more hawkish tone the Fed has recently adopted, the odds of a rate hike in June or July have risen. Fed action has the potential to trigger volatility in oil prices, the dollar and equity markets. But we do not believe disruptions will be overly significant.
4. Oil Prices: Production levels will likely remain high. We are not expecting to see cuts from OPEC, and U.S. production may drift higher over the coming year.1 We think oil prices will remain range bound, but the risk of another rout in prices cannot be ruled out.
5. Credit Spreads: Many fear that the U.S. credit cycle is in the late stages, which has triggered on-and-off selling pressure for high yield debt. We believe credit conditions are improving and high yield markets continue to look attractive, which would be a positive sign for the economy and equities.
6. Corporate Earnings: Earnings have been in a year-long decline. We think headwinds are fading, but investors need to see evidence that earnings results can turn positive. We are seeing forward guidance turn positive in key sectors such as industrials,1 and we expect better earnings results in the second half of this year.
7. Politics: There are a number of geopolitical events that could rattle financial markets, including the referendum on the U.K. leaving the European Union and the upcoming U.S. elections. High levels of uncertainty are a negative for risk assets, and the political backdrop is anything but certain.
Equity Markets May Be Poised for Outperformance
On balance, we see more positives than negatives for equity markets. A number of potential downside risks exist, with the two most prominent being questions over Fed policy and the rising value of the dollar. These factors could weigh on stock prices in the near term, particularly given uncertainty over global economic growth and corporate earnings.
Nevertheless, we have a positive long-term outlook for equities and believe they will outperform bonds and cash over the next six to twelve months. Should we see a price breakout to the upside, that would be a clear bullish sign, and could lead investors to believe that the downtrend evident over the past year has faded.