Key Points
• Positive growth, low inflation, climbing earnings and an accommodative Fed have pushed equity prices to record highs.
• We think these trends can continue, but also believe investment selectivity is growing more important.
Investors continued to mostly ignore escalating uncertainty in Washington and focused on the positives last week, mainly dovish comments from Federal Reserve Chair Janet Yellen. Stock prices rose for the week, with major indices hitting record highs.1 Technology led the way, while energy and materials also performed well.1 Telecommunications was the worst-performing sector and financials gave back some recent gains.1 Barring an unexpected exogenous shock, we expect volatility to remain relatively low through the summer.
Weekly Top Themes
1. U.S. monetary policy should remain equity-market friendly. In her comments last week, Janet Yellen stated that the neutral rate for the fed funds rate is “currently quite low,” and rates would not have to rise much more to become neutral. In our view, a neutral fed funds rate is closer to 2% than the 3% currently implied by the fed funds futures market.2 If this is accurate, it would likely be good news for economic growth, corporate earnings and the stock market.
2. Global monetary policy is starting to normalize, but still supports stocks. The Bank of China raised rates by 25 basis points last week and other central banks are becoming less dovish. We think this is good news since it reflects improving global economic growth, while overall policy remains easy. Central banks are still promoting liquidity, which should support equities and other risk assets.
3. Inflation remains surprisingly low. Although economic growth is improving and the Fed is normalizing, inflation has not increased similarly. Inflation should eventually react to tightening labor markets, but the process is taking a long time.
4. If the “Goldilocks” environment persists, we think equities can continue to make all-time highs. Low inflation, slow-but-positive economic growth, climbing earnings and a cautious Fed have contributed to record-high stock prices. We think these conditions should remain in place for at least the next 6 to 12 months.
5. Active fund manager performance has improved. According to Merrill Lynch, 54% of active large cap U.S. equity managers outperformed their benchmarks for the first half of the year and more than half also outperformed for the last four months.3 This is the longest such streak since Merrill Lynch began tracking this data in 2009, and it marks the first time a majority of managers outperformed for the first half of a year.3
Earning Are the Focus as Monetary Policy Shifts
The world is slowly (and finally) starting to shift from the great monetary experiment of extremely low interest rate policies in place since the financial crisis. This process will be bumpy and take some time, but it seems clear that the emergency conditions that drove these policies are now in the rearview mirror. Elements of the global economy still look hazy, but the world economy appears in better shape now than it has been in years.
We expect the Federal Reserve and other central banks to gradually increase interest rates, but policymakers have made it clear they will err on the side of caution and moves will remain data-dependent. Inflation has yet to pick up noticeably, which puts less pressure on central banks to tighten aggressively. In our opinion, slow but gradual increases in rates will put upward pressure on bond yields, but shouldn’t derail the equity bull market.
There are risks for the stock market. A key one is that equities are not cheap and could become expensive if earnings do not improve and keep pace with prices. We have a positive view on the earnings outlook, but think it will be critical for the economy to maintain a positive track for earnings and profits to improve.
On balance, we expect economic and earnings growth to remain decent, which should be enough to provide an ongoing tailwind for stock prices. Conditions are growing trickier, however, and we think selectivity will be critical since some areas of the market look more attractive than others.
Bob Doll is chief equity strategist at Nuveen Asset Management.