Key Points

  • Equity prices have taken a breather following a strong post-Brexit rally.
  • Technical conditions suggest the equity market is strengthening and selectivity is becoming more important.
  • If corporate earnings continue improving, we believe the rally should endure.

Equity markets digested a great deal of information last week. Corporate earnings continued to improve (particularly in the technology sector) and the U.S. dollar and oil prices declined. The Federal Reserve acknowledged financial risks have been diminishing, as the economy appeared to stabilize. Finally, second-quarter gross domestic product growth was reported to be weaker than anticipated. Despite all of the news, however, prices were little changed and the S&P 500 Index was essentially flat for the week.

Weekly Top Themes

Second quarter growth was weak, but consumer spending advanced. GDP expanded at only 1.2% for the quarter, well below expectations. Inventories represented the biggest drag and business investment was soft.2 However, consumer spending climbed 4.2% during the quarter.

The Fed appears to be starting to prepare markets for another rate hike. The Fed’s comments last week were more upbeat than previous statements. We do not expect an imminent rate hike, but we believe the Fed could raise rates in December.

Oil prices will likely remain under pressure. Oil has softened in recent weeks due to rising inventories and persistent oversupply. We expect these trends will continue and believe oil prices will remain in the $30 to $60 range for several years to come.

Evolving market leadership points to signs of optimism. Equity markets are little changed over the past few weeks, but internal market dynamics have shifted. Cyclical and more economically sensitive sectors have outperformed defensive, lower-volatility and higher yielding sectors. We believe this indicates investors are expecting better economic and earnings growth.

Technical signs for equity markets are also turning positive. In addition to these sector changes, the equal-weighted S&P 500 Index has outperformed the market-weighted index since the post-Brexit rally began.4 This means the average stock has outperformed the broader market. We think this is positive for future prices and argues for careful selectivity and active management.

Corporate Earnings and Profits Could Improve

U.S. equity prices are near record highs, and we believe technical conditions remain supportive for stocks. Despite the weak second quarter GDP report, we believe the economy is continuing its slow-growth pace, which should help equity markets. Corporate earnings have also turned in a positive direction. The recent slide in oil prices represents a potential risk as investors remain wary of another sharp downturn that could again act as a headwind for stock prices. Yet we believe that if oil remains range-bound, equities should not see significant contagion. Prospects for non-U.S. markets appear less rosy, however. Brexit-related worries may continue to plague Europe, and global economic growth remains challenged.

While equity markets have rallied strongly following the Brexit vote, government bond yields remain close to record lows despite signs of economic resilience. In our view, low yields are a reflection of lingering economic pessimism and a belief that central banks are primed to remain highly accommodative. The Fed has certainly indicated that it will remain cautious as regards its next rate hike and is highly attuned to both economic and financial market conditions. These factors are likely to keep bond yields from rising quickly or significantly.

Looking ahead, we believe corporate earnings remains the key variable that is needed to sustain the equity rally. The profits picture is slowly brightening, but it is too early to say that profits and earnings are on a clear upward trajectory. Nevertheless, we think a combination of a slowly growing economy, modestly improving profits and persistently low bond yields should provide a tailwind for U.S. equity prices. While valuations for stocks are not as compelling as they once were, we believe equities still look more attractive than bonds or cash.

Bob Doll is chief equity strategist at Nuveen Asset Management.