The domestic economy is much closer to normal that it has been in the last five years. With expectations that the U.S. economy will grow 3% in the second half, Greece’s immediate uncertainty behind us, Cuban and Iranian détentes winding their way through the political process, and little damage done by Chinese stock gyrations, there is a good chance the Fed increases interest rates in September or December; but additional Fed rate hikes will be small, few, and far between in 2016.
Remain pro-growth on a 6-12 month horizon in order to benefit from an improving economic backdrop and continued hyper-easy monetary conditions. Nonetheless, long dated Treasury and municipal bonds look increasingly attractive as yields rise and equities look increasingly vulnerable despite recent good market reaction. There were lots of panic attacks from 2009 through 2012 that caused some nasty stock corrections. However, when we didn’t go over the widely feared “fiscal cliff” at the start of 2013, investors showed signs of anxiety fatigue. As a result, it’s become harder to scare them and panic selloffs have been muted ever since. Thus, this year, the S&P 500 has fluctuated in a relatively narrow trading range.
The current earnings season should deliver better-than-expected results. Industry analysts have approached the latest earnings season by cutting their estimates, thus we are likely to see an upside earnings hook. Consumers are also becoming more confident and the personal saving rate is high relative to household wealth. Though dollar strength will hurt US profits and export competitiveness in the near-term, depressing manufacturing activity, this drag should eventually dissipate – especially as demand in the rest of the world improves. Crucially, the main secular forces that have kept growth down since 2008 – public and private sector deleveraging – are fading, which should allow the economy to expand at a sustained pace.
The euro area’s economy is recovering (Greek melodrama aside) with potential for a positive growth surprise later this year. There are several reasons to be optimistic about the euro area outlook and European equities: (i) the ECB’s aggressive quantitative easing (QE) program has depreciated the euro, which helps exports and corporate profits; (ii) large-scale QE is lifting confidence and smoothing the deleveraging process; (iii) lower oil prices are boosting GDP and household incomes; and (iv) credit conditions have eased, which may spur an increase in business investment. Despite this cyclical recovery, regional political risks remain a significant threat because of the euro area’s deep structural imbalances and high unemployment. The authorities are likely to prevent countries such as Greece leaving the euro in the short term, but their attempts at kicking the can down the road may eventually backfire. Meanwhile, the ECB will continue its aggressive QE program until at least 2016.
In Japan, more stimulus will likely to lead to a new cyclical upturn. Their central bank may use negative rates to incentivize Japanese corporations (which sit on more cash than the market capitalization of the entire Japanese stock market) to increase dividends and buy back stock. But Abenomics probably won’t permanently transform the economy’s medium-term growth outlook. Moreover, the stimulus is compounding the financial and fiscal risks facing Japan; real incomes have declined and comprehensive structural reforms are missing.
The next bear market will occur when the global economy sinks into the next recession. That doesn’t seem likely anytime soon given all the liquidity provided by the major central banks. In the past, recessions were usually caused by credit crunches that resulted when monetary policy was tightened to fight inflation. Currently, the central banks are providing liquidity to avert deflation; however, that does not mean that we can’t have a correction.
Michael Ashley Schulman, CFA
Hollencrest Capital Management