The Stock Market rallied hard in October, so the big question is… will it last? For some thoughts on that and our official 6 month forecast, read on.
First up is a daily chart of the S&P 500 over the last 12 months. The dramatic selloff in August, followed first by a failed rally attempt in September, and then a (so far) successful rally in October is clearly visible on this chart. Notice the “W” formation that this market action makes on the chart. Market technicians (people who spend most of their time and energy looking at charts, as opposed to the data and events that create them) are all aquiver at the sight of this “beautiful” chart pattern. To them, it’s all the proof they need that the correction is over and the market will continue to rally from here. But will it? We’ll try to answer that question by looking at the conditions that caused the decline and what’s likely to happen in the real economy going forward.
Report Highlights
- After falling 13% from June to August, global stock markets have rallied back with a vengeance.
- Is this rally sustainable, or was it fueled by short covering and M&A headlines?
- Volatility in recent months has intensified after years of relative calm in the market.
- The effectiveness of monetary policy as an economic stimulus is receding.
- We have a cautious outlook for stocks and other risky assets.
Central banks
The ability of central bankers to deliver sustainable economic growth is being called into question. This has roiled markets and raised volatility. In some European countries, interest rates on government debt is actually negative. In the U.S. and Japan, government debt has reached levels that are concerning to politicians, economists, and investors. After 6 years of government borrowing to stimulate economic growth, many are worried that central banks have exhausted their bag of tricks. And the biggest fear among the strategist class is that when (not if) the next recession hits the global economy, central bankers will have virtually no leverage and no tools with which to operate in their traditional ways.
Emerging markets
Concerns about China, Russia, and Brazil have caused investors to take a more pessimistic view of economic data as it is released. Some high-profile strategists, including Goldman’s David Kostin, go even further by saying that the emerging market decline is the third leg of the great financial crisis that began with the collapse of Lehman Brothers in 2008. We are not as pessimistic as all that, but emerging markets are getting a lot of our attention lately.
Global economy
Markets are likely to remain volatile as we digest third quarter economic and earnings releases. But we think developed market growth and earnings will probably muddle through. The IMF recently lowered their growth target for the global economy, but growth is still expected. See our forecasts later in this report for more details.
Asset allocation
We still prefer stocks over bonds, real estate, and cash. Specifically, we like European and US stocks. Our allocation to emerging markets has been below average for almost a year, and we are not ready to increase exposure just yet.
October Recap
We do not think that weak economic data represents more than a temporary slowdown. Much of the recent weakness around the world has been concentrated in manufacturing, while service sectors continue to grow and generate earnings and employment growth. In addition, developed economies have held up despite the downturn in emerging markets. We expect developed market equities to move higher over the next six months. Thus, we are overweight U.S. and Eurozone stocks, along with some other risky assets. See the table below for details.
Markets Freaked Out In August, Then Rebounded In October
The rise in volatility for the S&P 500, as measured by the VIX index, reached 53.3 at one point in August. By comparison, in 2008 it took three weeks after the Lehman Brothers collapse for volatility to reach that level, and a volatility reading of 53.3 surpassed levels reached during any of the Eurozone crises or after the Japanese Fukushima tragedy.
We believe that we’re in the midst of a mid-cycle slowdown, not a slide into recession. We’re looking for better economic numbers from the US and a gradual recovery in China. But our positive outlook for developed economies will need to be revised if we see signs of a slowdown from forward-looking indicators like business confidence, a sharp widening of credit spreads, or disappointing third-quarter economic data.
We expect a continuation of weak growth in emerging markets. But we worry that the actual figures could turn out to be worse than we anticipate. A further deterioration could be triggered by an acceleration of the recent capital flight from emerging markets. This would force central banks to draw down reserves in order to stabilize their currencies and inflation, further reducing the amount of liquidity available to domestic banking sectors and making the slowdown even worse.
Equities
We still have a slightly positive outlook on global equities, with a preference for developed markets. We are overweight Eurozone equities, where economic data is improving. We expect a continued rise in corporate earnings due to the uptrend in economic growth, low corporate funding costs, and persistent monetary support. We are also overweight Japanese equities, as a weak yen supports the earnings outlook, while QE remains a source of solid support. We are not very enthusiastic about emerging market stocks due to their weak economic backdrop and falling earnings, and UK equities, which are facing headwinds from a strong currency, and commodity exposure.
Forecast – U.S. Economy
Moderate expansion – Probability: 70%
We expect a slight pickup in US real GDP growth over the next 12 months, after temporary weakness in 2015. Improved US household and business fundamentals should support private domestic demand growth, although with a moderate drag due to a strong dollar.
The negative impact of the lower oil price on energy sector fixed investment has been significant, but is starting to fade. Against a backdrop of above-trend growth and falling unemployment, the Fed will likely start raising rates early next year. But we expect the pace of rate hikes to be much more gradual than in previous tightening cycles.
Strong expansion – Probability: 10%
US real GDP growth accelerates, rising significantly above 3%, propelled by an expansive monetary policy, improved business and consumer confidence, strong housing investment, and subsiding risks overseas. The Fed raises policy rates significantly more than markets are anticipating.
Growth recession – Probability: 20%
US growth continues to slow. Consumers save rather than spend the windfall from lower energy prices, while businesses lack the confidence to hire workers and boost investment spending. The Fed remains on hold.
Outright recession – Probability: 0%
Our indicators, both leading and coincident, point to continued growth in the U.S. The only thing that could cause us to change our view would be a black swan type of shock to the global economy.
Stock market outlook
The recent 12% decline in the S&P 500 Index is a correction, not the start of a bear market. Bear markets are typically associated with one of the following: economic recessions, central bank mistakes, or valuation extremes. None of these are evident, nor do we expect these conditions to show up over the next 12–18 months. By contrast, US economic growth momentum appears sluggish but solid, with housing and auto sales – two cyclical segments – accelerating to post-cycle highs.
Bond market outlook
We expect the 10-year US Treasury yield to trend modestly higher as the economy continues to grow, slowly reducing spare capacity, and in anticipation of the Fed policy rate liftoff later in 2015. Treasury yields experienced a volatile month as uncertainty over the timing and eventual extent of Fed rate hikes remained high, and concerns over global growth, including the poor performance of emerging market economies, kept risk aversion elevated.
Government bonds
Although we have not changed our interest rate forecasts, there is no question that the message from the FOMC was not one for rates to increase. The 10-year yield has been range bound between 2.05% and 2.25%. We do not see this pattern changing until the Fed changes its current stance or economic numbers surprise on the upside.
Commodities
Commodity prices showed signs of stabilization in September and October after sliding sharply in July and August. Although we believe commodity prices will begin to recover over the next 12 months, several headwinds remain in place and leave room for even lower prices in the short run. Slowing Chinese demand and insufficient supply adjustments in key commodities like crude oil suggest steady or even lower prices over the next 3 months.
Key Recession Indicators
Our 6 Month Forecast
Current Asset Allocations
Summary & Conclusions
While it’s great to see the market rally back from the nasty August selloff, we remain unconvinced that it will go much farther. There was a significant amount of short covering going on in September and October, and once the shorts have been covered there is no more demand from that source.
Another thing that bothers us is the lack of participation in the October rally. There are only a few, high-profile names driving the rally while most stocks remain stuck below their long-term trend lines. We need to see more breadth before we can become more enthusiastic about the rally.
Of course, there are still a host of obstacles facing stock market investors these days, and a rally won’t erase them. China is still struggling to get their economy back on a solid growth track. Emerging markets are in a bear market, and have been for a couple of years now. Who knows when that will finally get resolved?
In the U.S., earnings are punk and there is no sign that things will be much better over the next couple of quarters. Analysts are optimistic, but that’s in their nature (and their job description, apparently). They always begin the year with rosy predictions about double-digit earnings growth, and spend the rest of the year revising their estimates down, until they are low enough for the companies they cover to “beat” them. It’s a dance that has been in effect since the 1970s, and it won’t stop anytime soon.
In case you’re thinking that we’re pessimistic about the future, you can relax. We still like stocks, and we don’t see a recession anytime in the next 9 months. The problem is that growth and market gains will be slow and muted. But what’s the alternative? Cash is paying negative interest after taking inflation into account. Bonds are riskier than stocks, given the prospect of the Fed raising rates early next year. And commodities have been crushed, with no immediate indication of a rebound to be found. The best we can say is that maybe they have stopped going down, but that’s not much of an endorsement.
So our asset allocation bears out our forecast for the next 6 months. We’ve trimmed back a little on stocks, and added to alternatives like hedge funds and managed futures. At least they have a decent chance to move higher in a slow-growth environment like we’re in today.