For more than a year now, equity markets have enjoyed an unusual combination of low volatility and near-uninterrupted price gains due to a combination of accelerating economic growth, improving earnings, accommodative monetary policy and still-low inflation. This has been a near-perfect environment for stocks, but we think conditions could start to grow more difficult.
Economic growth should continue to improve, but expectations have risen, which means positive surprises will be harder to come by. At the same time, central bank policy is slowly tightening, which could contribute to market volatility. Additionally, accelerating growth and tighter policy may finally trigger an uptick in inflation, especially in wage inflation given the low level of unemployment. Should this occur, we expect bond yields will climb, which could jolt other financial assets including equity markets. We don’t expect yields to rise unimpeded, but an ascending period of peaks and troughs looks likely.
Such a backdrop, combined with more lofty valuations for stock markets, could signal trouble for equities. Also, we think high yield bond spread movements tend to be a good forward indicator for stock markets. High yield spreads have widened slightly in recent weeks.1 Should this continue, it could be bearish for stocks.
At this point, we think positive equity market momentum may be cresting, but we do not see the signals necessary that would presage the end to the bull market. As such, we think volatility is likely to rise and wouldn’t be surprised to see a market correction or consolidation before prices can sustain another prolonged increase. To be clear, we aren’t forecasting an end to the current economic cycle or to the equity bull market, but do think gains will be tougher to come by. As such, we would encourage investors to continue with a pro-growth investment stance and an overweight to equities, but we also to expect more bumps along the way.
Bob Doll is chief equity strategist at Nuveen Asset Management.
1 Source: Morningstar Direct and FactSet, as of 11/10/17