Despite a rocky start in 2016, global equities seem to be back on track and I continue to be optimistic about them over the long term, that is, for the next few years. Here’s why: Modest growth in what may potentially be the longest business and credit cycles ever, low interest rates, low inflation, and ongoing global central bank monetary policy support are going to be the primary drivers of global equities’ positive long-term performance.
That being said, I also believe that, over that same long term, global equities may deliver modest returns but with higher-than-usual volatility.
If that is indeed the case, what to make of equities over the near term, say the next few months? This is an important question, given that equities have had a massive rebound from February’s lows. Can the current uptrend continue a bit longer before the inevitable correction ensues?
In my view, the global equity backdrop remains supportive for several reasons:
- First, the U.S. Federal Reserve (Fed) will hold off on raising U.S. interest rates for the foreseeable future, including at its June meeting. From a domestic business cycle basis, looked at in isolation, one could make the case that the Fed should continue down the path of tightening it started in December 2015. However, I believe the Fed now has adopted a broader global perspective into its rate-setting process and as long as emerging markets remain vulnerable from a cyclical perspective―more on this below―the Fed is not going to make any preemptive rate move that could derail global growth. This is especially true in light of the fact that the U.S. economy now seems to be slowing as opposed to reaccelerating, as was the case last year.
- Second, from a cyclical perspective, emerging markets are coming off of their cyclical trough as oil and commodity prices rebound, inflation slows, and China coordinates the unleashing of its domestic monetary and fiscal support. The best evidence for that is the strength of emerging market currencies and continued softness in the dollar. To be sure, emerging markets in general and China in particular face serious longer term issues, and the current strengthening of the growth outlook does not come close to addressing them. Nevertheless, the improving stimulus-driven growth outlook for emerging markets also indicates that the likelihood of the global economy falling into a recession due to a downturn in emerging markets growth and commodity prices is quite small. That thesis, I believe, will hold true for the foreseeable future.
- Third, fear about U.S. corporate earnings growth has been a huge equity market overhang. While earnings growth will remain challenged and be modest at best, expectations of negative earnings growth may be coming to an end. Given the strengthening of commodity prices, the manufacturing economy, and the growth outlook for emerging markets, combined with a lower dollar, the first-quarter earnings season looks better relative to the previously pessimistic outlook, and the forward guidance from companies is a tad more optimistic. I believe this trend should continue for another few months or quarters.
- Finally, from what I can tell, investor risk positioning remains relatively modest. Since the equity markets’ February lows, the biggest recovery has been in what were the truly beaten down sectors such as energy and materials. It is especially noteworthy that the darlings of 2015―growth and momentum-driven companies―still remain without any investor support. If the outlook for emerging markets and Fed policy support gains some more traction, I believe we will see a transition to the growth-oriented stocks before we get to the inevitable downturn.
Fed Rhetoric as Risk Factor
So, what is the biggest risk to this optimistic near-term outlook?
The drivers for emerging markets growth and, consequently, a commodities and cyclical rebound, are pretty much in the bag. However, in a central bank-supported macro world, investor sentiment is as important as ever.
Therefore, if the Fed revives its hawkish rhetoric, the rosy outlook for equities may change quickly. The first evidence of that will not be in U.S. rates, which have been selling off despite equities doing well. Instead, it will show up in renewed strengthening of the dollar.
At the end of the day, if you are watching one thing in the markets, watch the dollar.
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