Clarksville, TN – Financial market headwinds for the next six to twelve months include political uncertainty in the U.S., a strengthening U.S. dollar, significant uncertainty surrounding Britain’s recent referendum on leaving the European Union (“Brexit”), and earnings growth.
Tailwinds include low oil prices, an improving labor market, and a low interest-rate environment.
International
Brexit
- The 52%/48% victory for the ‘leave’ campaign reflects a widespread distrust of Europe-wide policy-making and regulatory intervention in the UK as well as a skepticism about immigration and a nationalism which prefers more complete rule from the UK’s Parliament.
- The rejection of the favored choice of most of the UK’s political leadership and almost all countries of note has implications far beyond the UK.
- Financial market volatility was augmented by the resignation of the UK Prime Minister who will stay in office just to oversee the election of his successor.
- “In the near term, we expect elevated volatility and a rally in high-quality investments, such as intermediate- and longer- maturity investment-grade bonds and dividend-paying stocks.” – Nick Lacy, Chief Portfolio Strategist, Asset Management Services
- “The UK has two years to negotiate its exit from the EU. There is inevitably uncertainty around this move, and whether it will have a direct impact on economic growth over the next few years is clear. After all, most formal economic studies on the impact of a “Brexit” identified clear economic growth declines.” – Chris Bailey, European Strategist, Raymond James Euro Equities*
U.S. Economy
Growth
- Coming off a soft first quarter, the economic data look stronger into 2Q16, with the committee anticipating moderate growth in the near term.
- Inflation remains low, but Federal Reserve officials expect a gradual increase back to the Fed’s two percent target as the transitory impact of low prices of oil and other commodities diminish.
- Consumer spending has been supported by job growth and should continue to do so as the job market tightens and wage growth improves.
- The soft trend in fixed business investment can be attributed to decreases in capital spending within the energy sector and elevated levels of business caution. Uncertainties include the pace of global growth, the UK leaving the EU, and the U.S. presidential election.
Federal Reserve
- On Federal Reserve officials raising rates, Chief Economist Scott Brown stated “They’re looking to resume policy normalization, raising short-term interest rates at some point, but they shouldn’t be in any hurry.”
- Given the UK’s referendum vote to leave the European Union, “The probability of a rate move by the U.S. central bank (Fed) has actually shifted from a hike to perhaps a more accommodative stance, although the probability of any move is very low all the way through February 2017.” –Doug Drabik, Senior Strategist, Retail Fixed Income
- The November election is not as big a factor in the Fed’s decision- making process as the markets believe.
Strong U.S. Dollar
- The recent flight to safety boosts the dollar (against a range of currencies, not just the pound), which is likely to remain a restraint for U.S. exporters.
- The dollar appears to have overshot on the way up and has reversed somewhat, but changes to the perceived Fed policy path and uncertainties in Europe are likely to continue holding it up in the near term.
U.S. Equities
S&P 500
- “While the rally off the February low has made the situation feel a lot better, keep in mind that we have now gone more than a year without making a new all-time high. So we’re not out of the woods yet, even though the internal readings of the market still aren’t showing major deterioration under the surface.” –Andrew Adams, Research Associate, Equity Research
Valuations
- “The only metric that looks overvalued to me is Shiller’s Cyclical Adjusted Price Earnings model (CAPE), which at 26.1x earnings is about 10 points over its long-term average. Most of the other valuation tools are either marginally overvalued, or below their long-term average. Indeed, the trailing normalized P/E ratio for the S&P 500 is at 18.0x versus its average of 19.0x, while the price-to-free cash flow ratio is at 23.0x versus its average of 28.1x.” –Jeff Saut, Chief Investment Strategist, Equity Research
Earnings
- “While it’s true earnings have had negative comparisons since late 2014, revisions to earnings growth estimates have been improving for nearly four months. Manifestly, the positive to negative earnings estimate revisions (EER) is now at nearly a two-year high from its long-term average. Hence, the earnings worm seems to have turned.” –Jeff Saut, Chief Investment Strategist, Equity Research
Bond Markets
Flight to Quality
- “Over-accommodative monetary policies and a stampede of influence for firms to conduct M&A activity, stock buy backs, and pay dividends have resulted in financially-engineered balance sheets.” – James Camp, Managing Director of Fixed Income, Eagle Asset Management*
- On foreign demand, “the rest of the world is seeking out anything with positive yield. Combined with superior liquidity in the U.S. markets, foreign investors are gobbling this stuff up. Additionally, demand has spilled over to the corporate space, and concessions on investment-grade bonds are disappearing. There’s strong supply and demand is robust. As a result, spreads are tightening.” –Benjamin Streed, Strategist, Retail Fixed Income
- “All the talk about Fed rate hikes is going to be irrelevant in the big picture because everything is being overshadowed by high demand.” –Doug Drabik, Senior Strategist, Retail Fixed Income
- Regarding the Brexit vote, “the short-term effect is a flight to quality. Volatility is likely to remain as long as uncertainty prevails. It is important to know what you own and why you own it. Appropriate asset allocation is essential.” –Doug Drabik, Senior Strategist, Retail Fixed Income
Alternatives & Commodities
Alternatives
- “The environment is favorable for alternative strategies such as long-short equity because they can take advantage of lower correlations across stocks and the elevated volatility we are seeing in the market.” –Jennifer Suden, Director of Alternative Investments Research
- While fundamentals are looking up for alternatives, this is a strategy-specific environment rather than a bullish market for alternatives in general.
Commodities
- Oil prices have already near-doubled from February’s lows. The recovery should continue, reaching $60s per barrel toward the end of the year, and even higher in 2017. As energy and other commodities sustain their recovery, not all geographies will benefit. “While some commodity importers such as China and India are in better shape than we expected six months ago, we still see headwinds from commodity-centric economies such as Canada and Brazil. When these latter countries begin to pick up, their customers will face a rising import bill.” –Pavel Molchanov, SVP, Energy Analyst, Equity Research
Read the full July 2016 Investment Strategy Quarterly.
*An affiliate of Raymond James & Associates and Raymond James Financial Services.
All expressions of opinion reflect the judgement of Raymond James & Associates, Inc. and are subject to change. Past performance may not be indicative of future results. There is no assurance any of the trends mentioned will continue or forecasts will occur. International investing involves special risks, including currency fluctuations, different financial accounting standards , and possible political and economic volatility.
Investing in certain sectors may involve additional risks and may not be appropriate for all investors. Asset allocation and diversification do not guarantee a profit nor protect against loss. Alternative investments involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements, including minimum net worth tests.
Commodities and currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when overall are rising. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
