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June market update: What’s next for stocks?

The backdrop looks good despite volatility, but there are many moving parts at this stage.

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Dirk Hofschire's key takeaways

  • Need to see more earnings growth for the rally to continue.
  • A sharp and sustained interest rate increase is probably unlikely.
  • Conditions remain supportive for stocks, but anything can happen in the short term at this stage in the economy.
  • Uneven recovery globally—underlying improvement beneath the surface.

In what has become a seemingly common narrative, U.S. stocks advanced higher in the most recent month, their seventh straight month of positive gains. All the while, higher-quality bonds have provided more muted returns, and investments in various commodities have lagged.

With summer approaching, will the familiar uncertainty of policy risk persist? Or will slow economic improvements provide a positive backdrop for risk assets?

Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company, and Dirk Hofschire, senior vice president of Asset Allocation Research, discuss the markets in their monthly market update.

Schuster: Let's review the past month in the markets.

Hofschire: The markets have been doing all right. We've seen some of the same trends over the past few months. U.S. stocks have continued to go up. We’ve seen some areas lag, like global commodities and emerging-market stocks. We've also seen more volatility in recent weeks. Part of that’s been a backup in interest rates—especially long-term ones—to levels we haven’t seen for more than a year. That’s been negative for returns on high-quality bonds. We've also seen volatility in Japan. Japanese stocks have been one of the world leaders, and still are, year to date, but Japanese stocks actually fell 7% in one day. Their bond yields have been going up, so it’s been more mixed. We've seen more volatility, but so far U.S. stocks have done a reasonable job of navigating that environment.

Schuster: Let’s talk about U.S. stocks and risk assets, especially the ones that have done well for multiple months. What are some of the reasons for this strength in the markets?

Hofschire: The U.S. economy is still in an expansion. It’s a slow expansion, but it’s a midcycle one that appears to continue to gain greater traction. We have a housing market that is now in a full-blown recovery. Credit conditions are getting easier. Banks are lending more now, not just to corporations but to consumers, as well. Employment markets, while not robust, by any means, are continuing to see net job creation. You put that together with low inflation and extremely accommodative policies by the Federal Reserve, and it’s a supportive environment for economically sensitive assets.

Schuster: Can this strength continue month after month?

Hofschire: We've had some huge appreciation in stocks—especially this year. We don’t think stocks are expensive right now if you look at the price of the stocks relative to their earnings—the price-to-earnings ratio—but they’re more expensive than they were a few months ago.

At this point, I do think we need to see more earnings growth coming out of the market for the rally to continue. Earnings growth in the first quarter for S&P 500 companies was only about 3%. We had flat sales during the first quarter, margins are very, very high, but productivity has been flattening. It’s going to be interesting to see where growth is going to come from. Our outlook is that sales are going to pick up some during the latter half of the year.

Margins, while they’re probably not going to rise much more, may stay high because there’s not a lot of pressure on them from wages, interest rates, or commodity prices. Another highly important thing to stock investors is earnings per share. Companies have been engaging in a record amount of buybacks, reducing the share count. So, they’re essentially spreading the income or profits over a smaller number of shares, which makes the earnings per share (EPS) go up. Stocks have been getting a boost of about 1½% from EPS growth over the past year. That could continue even if profits don’t pick up materially. So, we’re probably not going to grow earnings as fast as we did very early in this cycle in 2009, but it’s still very possible to get mid-single-digit profit growth.

Schuster: Yields on U.S. Treasuries have risen recently. Should investors be concerned about a potential rising-rate environment?

Hofschire: Yes and no. 

Yes, investors should be concerned from the standpoint that yields are very low. If the economy continues to improve, even small moves up in yield do hurt bond returns. So I think bond investors may want to have more muted return expectations from what we've been getting from bonds over the past several years.

No, in that investors don’t want to overreact. A sharp spike in yields does not appear to be the most likely scenario. Why? We still have gradual economic improvement. We have modest inflationary pressures, and, obviously, we have a Federal Reserve that is very determined to make sure the economy gets on a sustainable path before it raises interest rates. So, this eventual rise in rates that may have started already is going to be an uneven one—it’s going to go in fits and starts. And we've seen just that in the past several weeks. A sharp and sustained increase that creates massive losses in bonds is probably unlikely.

Schuster: A lot of this hinged on a recent Fed reading and on investors trying to understand where the Fed is going with their policy, such as the potential tapering of quantitative easing. What are your thoughts on this?

Hofschire: Well, if current trends persist, where we continue to have the unemployment rate move down slowly, eventually the Fed is likely to begin tapering or stop purchasing as many bonds in its quantitative easing program. It will eventually move to a tightening stance. How quickly that happens is going to be dependent on the trajectory of the economy, inflation, and other things. Keep in mind that the Fed has gone to extraordinary lengths during this cycle to remove any downside deflationary risk. Coming out of the crisis, it’s showing us that it’s going to be patient and is likely to wait until it’s absolutely sure the economy is on firm ground. So, when the Fed does start to tighten, or taper, it’s going to be important. If the economy is getting traction and that’s the reason interest rates start to go up, then stocks can probably do fine in that environment. Stocks actually have a history of doing fairly well even when rates are rising. That’s more difficult for bonds; but, again, the timing and magnitude of those rate increases is going to be very important. A diversified portfolio in an environment where the economy’s getting better should still hold up.

Schuster: Any new information coming out of Europe, China, or Japan that you’d like to share?

Hofschire: In the global economy, we've seen a very uneven recovery. We do think there’s improvement, but it’s beneath the surface. The broad trend recently has been one of disinflation. Commodity prices have been weak. So far this year, a lot of economic data that has come out of China has been disappointing, as far as growth. Europe is still recessionary. We think there’s some underlying stabilization, but it has yet to really turn the corner. One of the bright spots has been Japan. As we've talked about in recent months, it is in an early cycle recovery. But recent volatility in Japanese markets shows that there are still a lot of challenges to putting that economy on a sustainable footing over the medium term. It’s going to require some fiscal and economic reforms that are not the easiest things to implement. So, I think the world economy is getting better slowly, but there still is a lot of uncertainty.

Schuster: So what’s an investor to do with all this information?

Hofschire: Well, there are still a lot of crosscurrents. In the midcycle, there tend to be a lot of moving parts. Sometimes it’s good news for economic growth, which may help stocks, but may be bad for bonds if rates go up. On the other hand, we’ve had several episodes here in the past few years in which interest rates did start to move up and the economy lost some traction, or something came out to knock the trend off course. And we got back to that period when rates started going down. So, in our opinion, conditions generally remain supportive for stocks, but after the big rally that we've seen recently, anything can happen in the short term. And it’s most important, as always, to stick to a more long-term strategy.

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