Central bank policy around the world has shifted decisively in recent months to provide additional monetary support to fuel economic growth. Financial markets have certainly welcomed this seemingly open-ended accommodative commitment from central banks, as evidenced by the fact that U.S. stocks once again reached new record highs. The key question for investors is whether easy monetary policy will be able to reverse the current economic soft patch.
At this point, it is all but certain that the Fed will cut rates at its end-of-July meeting. That’s already reflected in market expectations. But what will the Fed do after July? Many investors expect that the Fed will engage in a prolonged cutting campaign, and market expectations are for multiple cuts this year alone. But we doubt this is the case. Following the July meeting, we expect the Fed will adopt a wait-and-see approach. If economic data weakens, more cuts could come, but given we remain in an environment of below-4% unemployment and slow-but-positive wage growth, it’s hard to make the case for an extended easing cycle. There is certainly a risk that the Fed could disappoint by “only” cutting rates once.
Equities Look Less Appealing, But So Do Other Asset Classes
While our best bet is that the economic expansion will continue, the investment climate is becoming less appealing. Indeed, even if the trade threat diminishes, it is unclear whether an upturn in manufacturing and trade would be sufficient to spark a sustained rise in stock prices. And we also think investors are betting too hard on prospects for multiple interest rate cuts.
U.S. corporate business profitability (return on equity) already looks elevated by historical standards, which means it is hard to see how U.S. companies can achieve much more earnings upside in the current cycle. And valuations are certainly much fuller than they were at the start of the year. Prospects for earnings growth appear better in the rest of the world, but global economic growth would have to surprise on the upside for significant earnings growth to occur.
And the issue for investors is that other asset classes also offer dicey prospects. Given current yields, developed market government bonds look unattractive unless the world enters a recession. And many areas of the fixed income credit markets appear to offer limited upside in absolute terms even in a benign economic climate. Gold has broken out to the upside, but unless the U.S. dollar experiences a significant devaluation, it is hard to get excited about commodities in aggregate. And cash still offers relatively low yields.
As a result, we think the current environment will remain one in which selectivity and flexibility are critical—across all asset classes. Within equities, this means focusing on companies with the ability to generate free cash flow, those that have pricing power or other competitive advantages and those that are positioned for an eventual modest upturn in economic growth.
Robert C. Doll, CFA, is chief equity strategist and senior portfolio manager at Nuveen.