Key Points

• Equity markets rallied strongly last week as some glimmers of hope emerged.
• Investor sentiment remains depressed, however, and we expect volatility will persist.
• We think investors should grow less bearish over the coming months, and we have a cautiously optimistic view toward equities.

Equity prices soared higher last week around the globe. In the United States, the S&P 500 Index climbed 2.9%, and gains in Europe and Asia were even higher.1 However, U.S. stocks continue to lead the pack year to date.1 At least some of the gains can be attributed to an oversold bounce and overly negative sentiment. Relative stability in oil prices and in China, along with decent economic and earnings data, helped as well. Many investors remain skeptical about the sustainability of last week’s rally since it came without much of a fundamental shift in the negative feedback loop narrative that has driven financial markets for much of this year.

Weekly Top Themes

1. Energy sector issues have not been spilling over into the broader economy. The long-term collapse in oil prices has resulted in earnings setbacks and credit deterioration for energy companies. At the same time, however, we are still seeing improvements in consumer spending, broader credit growth and the jobs picture, which suggests that a wider contagion is not occurring.

2. The labor market in particular appears resilient to downside pressure. Last week’s unemployment claims fell by a better-than-expected 7,000 to 262,000.2

3. Inflation is slowly creeping higher. The headline Consumer Price Index was unchanged in January, but core CPI rose 0.3% last month. This is the largest increase since 2006 and brings the year-over-year increase to 2.2%.3 Given the strength of the dollar and the drop in oil prices, we attribute the increase in inflation to firming domestic cost pressures — specifically the tightening jobs market and rising consumer spending.

4. We expect modest economic and earnings growth in 2016. In some ways, it is surprising that the years-long zero-interest-rate policy in the United States has not produced better growth. In our view, this is due to the fact that it occurred while fiscal policy was contracting and consumer spending remained low. It appears that these trends are ending, and we believe government and consumer spending should promote additional growth. Our best guess for 2016 real gross domestic product is 2.5%.

5. The unsettled presidential race could spell trouble for the financial markets. Investors loathe uncertainty in politics. Should it come to pass that one of the nontraditional, non-establishment candidates (e.g., Donald Trump or Bernie Sanders) gets elected, there is good reason to believe that they will not operate under traditional restraints, and it would be difficult to forecast their policies. This could result in additional market volatility and downside pressures on equities.

What Will it Take to See Risk Assets Recover?

Some glimmers of hope emerged last week. Oil prices stabilized a bit and investors grew less concerned that the United States might follow the lead of other countries and move toward a negative interest rate policy. These were only glimmers, however, as investors remain deeply pessimistic about global economic growth. The fact that government bond yields did not bounce last week in line with equity prices demonstrates that investors are not moving from bonds into stocks as they would if sentiment were improving.

This suggests that financial markets are not yet out of the woods. A sustained rally in risk assets such as equities would require several conditions. Oil inventories must fall, resulting in more stable prices. Additionally, more clarity is needed surrounding the Chinese economy and yuan. Globally, monetary policy must become more certain, along with improved manufacturing and trade data.

We believe these trends should emerge over the coming months, but there is still considerable uncertainty about the near-term, especially since investor sentiment is so depressed and out of line with economic fundamentals. If and when economic data improves, investors should become less bearish, but it will take some time. We remain cautiously optimistic about equities over a six- to twelve-month time horizon, but also expect relatively high levels of volatility to persist.

1. Source: Morningstar Direct, as of 2/19/16
2. Source: Labor Department
3. Source: Bureau of Labor Statistics

Bob Doll is senior portfolio manager and chief equity strategist at Nuveen Asset Management.