Quarterly market update: Q2 2016 key takeaways

After a rocky start to the year, a stabilizing global economy should help support stocks.

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Each quarter, Fidelity's Asset Allocation Research Team (AART) compiles a comprehensive quarterly market update. Here are four key takeaways for the second quarter of 2016. For a deep dive into each, read the Quarterly Market Update: Second Quarter 2016 (PDF) or the interactive pdf.

Let's look at how the markets did in Q1.

Market summary: Tepid global growth gets markets off to a volatile start

Continued concerns about China's outlook and the trajectory of the global economy weighed on sentiment at the start of 2016, causing a steep drop in global risk assets during the first few weeks. Government bonds and gold benefited from the risk-off environment.

However, the tone reversed sharply mid-quarter amid the steady U.S. economy and easier global monetary policy, including the Federal Reserve (Fed) softening its rate-hiking stance. The worst performers in 2015—emerging-market equities, commodities, and non-U.S. currencies—suffered further losses in the first several weeks of 2016, before rebounding to finish with Q1 gains. We expect global economic stabilization will provide favorable support for equities, but elevated volatility is likely to continue. Inflation-resistant assets may offer protection against an upside surprise.

Economy/macro: Late-cycle indicators rise in U.S., but the global economy likely to stabilize as 2016 progresses.

Global economic growth remains tepid, but we expect the global environment to be stable in 2016. China and several other emerging markets, such as Brazil, face recessionary pressures, while most of the developed world remains in a slow expansion. China's economy faces massive industrial overcapacity and an overleveraged corporate sector, but the policy emphasis on stability and fiscal stimulus makes a near-term stabilization the most likely scenario. Leading indicators of global manufacturing activity show incipient signs that global trade and industrial activity may have bottomed. Countries that are highly dependent on commodity exports and trade with China have suffered in recent years, but they may benefit the most if China and the global economy can find their footing.

The U.S. economy faces low odds of a recession in 2016, due in large part to a healthy household sector. With labor markets continuing to tighten and inflation remaining low, U.S. consumers have enjoyed solid real (inflation-adjusted) income gains and have experienced a steady rise in future real wage expectations. The current U.S. expansion is a mix of mid- and late-cycle dynamics. Rising late-cycle indicators include tighter bank credit for businesses and emerging signs of profit margin pressures.

Global policy easing continued during Q1. The Bank of Japan and European Central Bank eased monetary conditions, although their negative policy rates did not weaken their currencies and may be an example of the limits of monetary policy. The Fed lowered its forward rate-hike guidance to be more gradual and closer to market expectations, which reduced financial pressure on China. Due to the more mature U.S. business cycle, risks in China, and uncertainty around unconventional monetary policies, we maintain an expectation of elevated market volatility. However, any stabilization in the global economy may support risk assets, and the potential for upside inflation surprises was not reflected in prices at quarter end.

Four themes

1. Time to pay attention to inflation?

The economy's transition from a mid-cycle to a late-cycle phase typically involves a pickup in inflation indicators, with commodity prices and wages tending to accelerate. These rising input-cost pressures adversely affect profit margins and credit conditions. Today, wage inflation is gaining traction, but commodity inflation remains generally absent. However, oil futures are at levels that could lead to an outright decline in non-OPEC (primarily U.S.) production in 2016, since drilling new wells may not be cost effective for oil producers if prices stay low. Reduced investment in future production could, therefore, bring greater supply-demand balance, and higher prices, as the year progresses. With core inflation already firm, any stabilization in oil prices could push headline inflation higher over the course of 2016.

Late cycles have the most mixed performance of any business cycle phase, with more limited overall upside than mid-cycle phases. There is less confidence in stock performance, though stocks have typically outperformed bonds. Inflation-resistant assets, such as commodities, energy stocks, short-duration bonds, and Treasury Inflation-Protected Securities (TIPS) typically have performed well relative to other assets.

2. U.S. stocks: After initial wobble, most categories turn positive.

Stock markets got off to a rocky start in Q1, but most categories ended the quarter in positive territory. Non-cyclical sectors outperformed, with telecom, utilities, and consumer staples leading the way. Earnings expectations dropped amid concerns about growth, dollar strength, and low oil prices, but the market's muted outlook may pave an easier path to upside surprises. Companies have used more of their cash for share buybacks, a strategy often employed as investment opportunities become more limited in a maturing cycle.

A disciplined business cycle approach to sector allocation can produce active returns by favoring industries that benefit from cyclical trends. For example, the late-cycle phase has historically rewarded inflation-sensitive sectors such as energy and materials. U.S. equity valuations are somewhat above their longer-term historical averages, but are likely to sustain a level closer to the average of the past 20 years. Valuations and inflation historically have a negative relationship, but inflation has room to rise from today's low levels and still be generally supportive of higher price-earnings multiples.

3. International stocks and global assets: Emerging markets, gold outperform

In a volatile quarter for risk assets, emerging-market stocks outperformed developed-market stocks. Unlike much of 2015, currency was a positive contributor, as dollar weakness provided a boost for U.S.-based investors. Gold prices benefited from the risk-off environment, and commodities recovered from weakness at the beginning of the quarter to finish roughly flat. Forward-looking corporate earnings estimates for non-U.S. stocks have fallen to more realistic levels.

This may provide potential for companies to beat expectations, particularly if currency values remain relatively stable. Non-U.S. equity valuations are attractive relative to the U.S. and to history, particularly in the peripheral eurozone countries and in emerging markets. Despite facing numerous cyclical challenges, emerging markets have favorable long-term prospects, as we expect economic growth in these countries to notably outpace that of developed countries over the next 20 years. Non-U.S. equities also provide ample opportunities for active management.

4. Bonds: Widespread gains in Q1

Interest rates dropped sharply during the first quarter, resulting in the outperformance of long-duration bonds and positive gains across every major bond sector. Most credit spreads narrowed, but they remained somewhat above their historical averages for both corporate and emerging-market debt at quarter end. High-yield investors continue to price in a default rate that implies a significant deterioration in the fundamental outlook.

While the fundamentals for high-yield companies have weakened amid energy-sector challenges and rising U.S. late-cycle indicators, they remain considerably more favorable than the overheated episodes during the 2000s. Inflation expectations remain near multi-year lows, making TIPS an attractively priced hedge against potentially higher inflation. Fixed-income strategies with designated allocations to both high-quality bonds and higher-yielding sectors: (e.g., high-yield bonds, leveraged loans, and emerging-market debt) have exhibited consistent downside protection that may make them attractive components of a diversified portfolio.

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The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop dynamic asset allocation recommendations for the Global Asset Allocation Division of Fidelity Asset Management (FAM), the investment management arm of Fidelity Investments. Lisa Emsbo-Mattingly, director; Dirk Hofschire, senior vice president; Jake Weinstein, senior analyst; Austin Litvak, senior analyst; and Caitlin Dourney, analyst contributed to this report. Christie Myers, director, and Kevin Lavelle, vice president, Fidelity Thought Leadership, provided editorial direction. The information presented above reflects the opinions of the authors, as of March 31, 2016. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
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Investing involves risk, including risk of loss. It is not possible to invest directly in an index. All indices are unmanaged.
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