Key Points

  • After six weeks of calm, equities dropped sharply on Friday in light of a spike in government bond yields and growing uncertainty over global monetary policy.
  • We believe equity markets should be able to withstand rising yields and remain attractive compared to bonds. As such, we favor an overweight position in stocks.

U.S. equities were relatively quiet last week before falling sharply on Friday, as the S&P 500 Index declined 2.4% for the week.1 Global sovereign bond yields also spiked on Friday.1 Selloffs in both asset classes were triggered by rising uncertainty surrounding global monetary and fiscal policies. In other markets, oil prices rebounded from a two-week decline due to falling inventory levels.

Near-Term Downside Pressure May Persist

Equity markets were remarkably stable for most of the summer before Friday’s sharp decline. The immediate cause appeared to be the European Central Bank’s decision not to expand its bond-buying program, and a growing sense that the Federal Reserve will raise rates this year. In our view, the selloff was magnified by high leverage on the part of many hedge funds and professional money managers. When volatility remains low, leverage tends to increase in the search for additional returns. Downside shocks can be exacerbated by these positions. Given that confusion and concern over central bank policies are likely to persist, and since there is probably more leverage that needs to unwind, we would not be surprised to see some additional near-term weakness in equity markets.

Weekly Top Themes

Weak Institute for Supply Management readings in August renewed concerns over a growth slowdown. Both the ISM Manufacturing and Services Indices were worse-than-expected last month. We do believe overall economic growth will accelerate, but this is a negative trend with business confidence soft.

Regardless of who wins the election in November, the odds of corporate tax reform surrounding repatriated earnings are growing. It is likely that any potential new tax revenue could be used to fund new infrastructure spending.

The Fed appears on track to raise rates this year, despite a recent downtick in economic data. The odds of a September hike seem low; we think December is more likely.

Given current inflation trends, the Fed may be falling behind the curve. Inflation is hardly a problem, but long-term trends show inflation accelerating modestly. Price levels are creeping up, and monthly jobs reports clearly show a slow increase in wages.

Equities Should Weather Higher Bond Yields

Even before Friday’s spike, global sovereign bond yields have been trending higher over the last six weeks. Yields have experienced upward pressure due to decent (albeit far from stellar) economic growth, modestly rising inflation, anticipation over Fed tightening, uncertainty about ECB and Bank of Japan policies and signals of forthcoming fiscal stimulus in the United States, United Kingdom, Germany, France and elsewhere.

This increase (and the potential for more) is undermining equity market sentiment.But we believe equities should remain resilient. First, from an economic perspective, we think yields are rising for good reasons. Specifically, improving global nominal growth appears to be driving the increase rather than a sharp adjustment in monetary policy or a lack of confidence in policymakers. Secondly, from a technical perspective, stock prices have been resilient in the face of climbing yields (at least before Friday’s selloff). Additionally, equities appear relatively cheap compared to the extremely low sovereign bond yields around the world.

As such, we maintain a reasonably constructive view toward both economic growth and equity markets. We expect the global economy will be marginally better than expected over the coming year and believe monetary policy will remain constructive for risk assets. The Fed is the lone major central bank on course to raise rates, but even a December increase represents a once-per-year increase pace, which is hardly restrictive. We will likely see ongoing occasional pockets of weakness in the equity markets, but we still believe it makes sense to overweight stocks and underweight government bonds.

Bob Doll is chief equity strategist at Nuveen Asset Management.