August market outlook: A peculiar rally

With valuations of defensive assets high, consider rebalancing into inflation-sensitive assets.

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It’s been an unusual environment in the markets post-Brexit. Dirk Hofschire, senior vice president of asset allocation research, offers insight on what this may mean for investors in his monthly market catch-up with Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company.

Schuster: What’s been going on most recently in the markets?

Hofschire: It’s been an interesting last few weeks in the markets. The Brexit vote for the UK referendum to leave the EU shocked the markets for a few days. The stock market went down, bond yields plunged as investors went into safer assets, but then after that it's been a bit of a peculiar situation in July—an anomaly where we've had the stock market moving to all-time highs here in the U.S., but bond yields have actually stayed near all-time lows.

So, I don't know exactly what's going on. I think in some cases it's because the news hasn't been bad enough to justify a big sell-off in stocks, nor good enough to justify a big sell-off in bonds. Maybe there is just enough liquidity in the markets, right now, where everything can go up for a moment in time, but at any rate it's been very unusual here the last few weeks.

Schuster: Can this unusual environment continue?

Hofschire: Well, let's start with U.S. Treasury bond yields, which hit near-record lows in July. And there are a lot of good reasons why bond yields are low. When you think about fundamentals now, it's not just the fundamentals here in the U.S. because these are global assets. It’s slow global growth, low global inflation, and monetary policies around the world that are really still in easing mode for many countries.

You also have a lot of technicals influencing the bond market; supply of Treasury bonds and other sovereign papers have actually been going down as many central banks have been buying these bonds through quantitative easing. You've seen lower issuance from governments as deficits have gone down, and demand has been very high.

Demographic changes have led to more people seeking income-producing investments and the current regulatory environment requiring banks to hold more high-quality assets has caused financial institutions to buy more bonds. So, many things are going on and these technical factors may not reverse any time soon. What we're thinking about today is these low yields are still suggesting that the market is not expecting any pickup in growth or inflation, either in the short- or long-terms.

Our outlook is we're starting to see some signs that the global economy is stabilizing. Inflation here in the U.S. is still low, but wages are picking up. We're seeing some indicators of a late cycle pattern, which is usually a more inflationary stage, and those signals are picking up as well. So, there's very little inflation and growth priced into the bond yields right now, which to us makes an upside surprise in inflation and growth a little bit more likely.

Schuster: What does that mean from an investment implications standpoint?

Hofschire: When you come back to asset allocation, these low yields are one of the reasons that stock valuations have gotten pushed up. The overall stock market here in the U.S. doesn't seem to us to be completely unreasonable in terms of valuation levels, but you have hit some extremes in what many consider bond proxy sectors: high dividend payers, places like utilities, and REITs. They’ve hit near all-time highs in some of their valuations relative to themselves historically and relative to the overall market.

I think it’s a bit tough for an investor now because a lot of people are seeking some safety, seeking some income, and now a lot of these more defensive assets or perceived defensive assets are very, very expensive relative to other things. So, especially if we move toward greater late-cycle movement later this year, diversifying may not mean overloading on defensive assets. It may actually mean balancing out with some more inflation-sensitive assets just in case we do get an upside surprise in inflation.

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