OCEAN CITY — The market is corralled within a range. Equity indexes have been range-bound in the past year, as has the U.S. dollar. We believe the equity market is more a “buffalo” than a bull or a bear. A buffalo market tends to roam over a long period of time, is herd-like and rather heavy, and can run the other way when worrisome obstacles get in the way. We see the possibility of several events this summer creating such obstacles.
As we’ve noted in the past, June alone presents markets with an OPEC gathering, a Fed meeting, a British referendum on European Union (EU) membership and the approach of the U.S. political conventions. We don’t expect as much pressure on markets as we saw at the start of the year. And our base case does not include potential volatility triggers like swings in oil prices, a Fed rate hike or a poorly-received move by another major central bank, a U.K. vote to exit the EU, a negative outlook for China’s growth or unexpected developments in the U.S. election cycle. We do, however, anticipate concerns with such possibilities to keep risk aversion elevated. As a result, we believe a balanced and diversified approach to investing in the markets is likely to be the best way to feel at home in this range-bound market.
In this environment, it’s likely to be difficult for U.S. equity valuation multiples to expand above their current levels. Any further upside would probably be borrowing from returns in 2017 or require an earnings boost for the S&P 500. We don’t rule out a modest one given the slightly improving global macroeconomic and financial conditions, the subtle weakness year-to-date in the dollar and firmness in prices of commodities, particularly oil. However, we assign a fairly low probability to a major positive earnings surprise scenario. Moreover, unexpected outcomes from the kind of events we anticipate could renew pressure on equity markets. And since valuations aren’t cheap, in our view, the markets are more vulnerable to negative news, or even anticipation of it. That said, there are also risks to the upside if the adverse outcomes do not materialize.
We believe a fully balanced portfolio strategy is most effective in this environment. Within the range-bound market indexes, a rotation from growth to value has been developing. This rotational tilt is in its early stages and may seem choppy, but as we move further through mid-cycle, it should gather momentum. Opportunities to outperform market indexes are more than likely to come from tilts within the asset classes or long-term investment themes.
More cyclical assets such as Emerging Market equities have significantly underperformed in the last few years; as investment flows for contrarian and value-based investments grow these areas should show more positive trends. A number of long-term investment themes should draw inflows of capital in the years ahead. They include the advanced technology cycle, personalized medicine and longevity, greater leisure time, the shift in global consumer spending from goods to experiences, infrastructure redevelopment, open source data access, energy storage, water scarcity and the aerospace and defense build out. As capital commits to these areas the earnings base of the affected industries and their leading companies should expand. In general, however, we believe a balanced portfolio is the best approach at this time. Outlook: Continued improvement Against this backdrop, the broader macro environment is moving further into the later mid-cycle stage. In our view, we remain in a mode of slow but improving growth, with housing and spending data continuing to suggest a solid outlook for the American consumer. Global financial conditions are stabilizing thanks to a steadier dollar, tightening credit spreads and oil prices rallying 90% off their February lows. If we should see a stock market drawdown that’s larger than expected in the summer months, and greater growth for earnings and the global economy, we would consider readjusting our tactical positioning by adding to areas that have corrected too far.
We acknowledge that this business cycle is getting long by historical standards, but it is not unreasonable to expect that it could continue to expand next year and rival or even exceed the one of the 1990s in duration. Potential drivers of such a scenario are that this time around growth at the nominal level is slower, with lower inflation readings and more extensive central bank easing is playing the role that fiscal policy normally does.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)