Key Points

• Following a strong post-Brexit rally, equity prices have stabilized in recent weeks.
• A number of positive factors could push prices higher, but these are balanced by several risks.
• On balance, we think the positives outweigh the negatives, but caution that markets are likely to remain uneven.

Most financial market developments occurred outside of equity markets last week. The U.S. dollar came under pressure following a generally dovish tone from the July Federal Reserve policy meeting minutes. Oil prices continued to advance amid ongoing speculation about production cuts. U.S. equities were up modestly last week, with cyclical areas such as banks, semi-conductors, autos, materials and energy leading the way.1 Real estate, telecommunications, drug companies and utilities lagged.1

Weekly Top Themes

U.S. manufacturing activity is likely to accelerate. Retail sales have been solid and manufacturing inventories have been declining.2 This combination suggests a modest pickup in manufacturing in the third quarter.

We expect a Fed rate hike later this year. A September increase is a possibility, but unlikely. We think December is a better bet.

It is hard to see how the United Kingdom will avoid a recession. The post-Brexit rules could take years to be finalized, creating ongoing uncertainty for businesses. The silver lining is that Brexit effects remain contained, meaning that a UK recession will not necessarily expand to the eurozone.

Low bond yields remain supportive of equity prices. While we expect upward pressure on bond yields due to improving economic growth, the Fed and other central banks remain acutely attuned to keeping financial conditions stable and are unlikely to tighten policy quickly or dramatically. As such, bond yields are unlikely to increase sharply.

It will be difficult, however, for equity prices to advance without additional support. Equity indices have again hit new records, but we believe fundamental changes may be necessary for prices to continue advancing strongly. Specifically, earnings would have to improve further and/or investor flows would have to turn notably toward stocks. Neither is out of the question, but aren’t likely.

The Back-and-Forth in Stocks Will Likely Persist

Since the initial fallout from the Brexit vote, U.S. stocks experienced a strong rally and have been trading sideways and marginally higher. This sparked the all-too- familiar bull versus bear debate, leading us to list the positive and negative factors for equities.

Reasons to be positive:

1. If yields remain low, equity valuations should have room to advance.
2. Earnings have been improving modestly and forward guidance has been solid.
3. Global policymakers have been hinting at fiscal stimulus and we expect increased spending in the U.S. regardless of the outcome of November’s elections.
4. The U.S. political outlook is becoming clearer, and it appears our government will continue to be divided (which isn’t necessarily bad for financial markets).
5. The global banking system remains reasonably healthy thanks to decent balance sheets.
6. Brexit-related risks appear contained.
7. U.S. economic growth is reasonably solid and the global economy appears on track, outside of the UK.
8. Oil prices have stabilized and have become less of a factor driving equity markets.
9. Chinese currency risks have diminished as price depreciation has been steady and even.
10. Bipartisan support for corporate tax reform appears to be growing and could occur in 2017.

Reasons to be cautious:

1. Global government bond yields appear artificially low and a possible spike could disrupt financial markets.
2. Central banks have exhausted their policy options and have little ability to respond to any new crises.
3. Financial markets appear overly complacent about the prospects for Fed rate hikes.
4. Expectations for future corporate earnings may be too high.
5. Additional fiscal stimulus and a lack of monetary policy options could put upward pressure on global bond yields.
6. Several months remain before the U.S. elections, and uncertainty levels could rise again.
7. Geopolitical uncertainty and terrorism risks (especially of the lone wolf variety) remain high.