Each quarter, Fidelity's Asset Allocation Research Team (AART) compiles a comprehensive quarterly market update. Here is a summary of their outlook in light of the Brexit shock to markets, plus four key investor takeaways for the third quarter of 2016. For a deep dive into each, read the Quarterly Market Update: Third Quarter 2016 (PDF).
First, let's look at how the markets did in Q2.
Market summary: Choppy global markets surprised by Brexit
The late-June U.K. vote to leave the European Union unleashed more political and economic uncertainty on the markets, leading to a rise in volatility and a further drop in bond yields. An expectation of even easier monetary postures by the world’s central banks added fuel to the global sovereign-bond rally and pushed trillions of dollars of government bonds into negative-yield territory. A gradually steadying global economy helped beaten-down commodities bounce back during Q2, and most assets posted decent gains for the first half of 2016. We expect the Brexit aftermath to prolong the process of gradual global economic stabilization. While we believe stabilization will ultimately provide support for equities, heightened volatility is likely to continue.
Peak globalization presents rising risks
Brexit is the most visible and tangible sign so far that globalization is under heavy political pressure, and the U.K. may be an example of the negative impact that anti-globalization measures could have on economic growth. On a cyclical basis, political uncertainty is likely to weigh heavily on business sentiment in the U.K., given its reliance on Europe as an export market. Over the long term, the potential for dramatically limiting immigration and losing its status as Europe’s financial center would substantially reduce the U.K.’s secular growth outlook.
After two decades of rapid integration spurred by technological advances and more countries joining the rules-based multilateral system, economic openness has stalled in recent years. With free trade and cross-border flows of capital and labor coming under political fire in many advanced economies— including the U.S.—future policy decisions will affect risks to the market-oriented global order. In the U.S. and Europe, policymakers may shift toward more accommodative fiscal policies to help assuage rising populist sentiment, and anti-globalization policies may boost labor costs, spur inflation, and put pressure on profit margins.
Economy/macro: More gradual shift to U.S. late cycle, higher economic risk abroad
Global stabilization remains the most likely underlying trend, albeit a more prolonged process with greater downside risks following Brexit. The U.K. may be headed toward recession, and Japan slipped into a mild contraction as a stronger yen pressured exports. Political uncertainty unleashed by Brexit is likely to dampen sentiment and provide a stiff headwind for business investment in the rest of Europe, but reasonably healthy household sectors should help support activity. Relatively steady expansions in the world’s two largest economies—the U.S. and China—are supportive of global growth. China’s economy still 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.
The U.S. economy continues to face low odds of a recession in 2016, largely due to a healthy household sector. Wage growth may be low and job gains may be slowing, but wage inflation is picking up cyclically and labor-market slack continues to fade. The current U.S. expansion is a mix of mid- and late-cycle dynamics, with tighter bank credit for businesses and profit-margin pressures evidence of late-cycle indicators.
Markets shifted to expecting an even softer monetary stance amid global weakness, as expectations for additional Fed tightening were eliminated during Q2. Negative policy-rate moves in Europe and Japan preceded sharp declines in the prices of their banking shares, highlighting that negative rates may run counter to their intended goals and that ultraaccommodative monetary policies may be hitting limits of effectiveness. However, any stabilization in the global economy may support risk assets. Rising oil prices, the low base effect of inflation, and record-low bond yields may indicate that the potential for upside inflation surprises is not priced in. Due to the more mature U.S. business cycle and the expectation of continued political and policy uncertainty, we maintain an expectation of elevated market volatility.
Four key themes
|1.||U.S. stocks: Modest gains across most categories, dividend-yielding sectors led|
Energy was the strongest sector in Q2, rebounding amid a rally in oil prices. Falling rates boosted dividend-yielding sectors—such as telecom, utilities, REITs, and consumer staples, while more cyclical areas of the market—such as technology and consumer discretionary—lagged. Amid record-low bond yields, investors have bid up the valuations of higher-dividend-paying stocks, placing a premium on companies with high payout ratios. In particular, utilities and consumer staples are expensive relative to their own histories and to the broader market.
Despite a few consecutive quarters of weak earnings, profit margins (outside of the energy sector) have held up and remain close to all-time highs. While earnings expectations have trended downward this year, company guidance and ex-energy expectations stabilized during Q2. With oil prices rebounding and the dollar stabilizing, lower expectations may provide an opportunity for earnings to surprise to the upside. Energy stocks have traditionally outperformed during the late-cycle phase and dispersion between companies in the sector provides for active security selection opportunities.
|2.||International stocks and global assets: Commodities and commodity stocks outperform|
Commodities and commodity-producer equities continued their rallies in Q2. The strong dollar was once again a headwind for equity returns in most foreign markets for U.S.-based investors. As a quasi-currency, gold may be benefiting from global policy easing and falling real interest rates, and gold mining equities provide portfolio diversification. Earnings expectations for most regions appear to have stabilized at low levels. Relative to U.S. equity income, global equity-income markets can offer higher dividend yields, as well as diversification through breadth in sector and regional-income sources. Despite cyclical challenges, emerging markets have favorable long-term growth prospects and historically attractive valuations, which should provide a favorable secular backdrop for EM assets. Non-U.S. equities can also provide ample opportunities for active managers. Fidelity's research shows that funds in Morningstar's foreign large category outperformed their prospectus benchmarks by an annualized average of 0.85 basis points from 1992-2014.
|3.||Fixed bonds: Easier monetary policy stokes broad-based bond rally|
Bonds posted positive returns for the second quarter in a row, as interest rates fell and credit spreads tightened. Long-duration and lower-credit-quality categories led, with some categories registering double-digit returns year to date. Bond yields fell near their all-time lows, but credit spreads remain near their historic averages. The low-rate environment continues to support corporate balance sheets as debt-servicing costs remain low relative to cash-flow receipts. High-yield bonds have benefited from higher oil prices and more favorable liquidity conditions, but rising late-cycle signals may present headwinds. In the muni market, technical and fundamental factors continued to show strength, as the supply of new issuance remains below demand and tax revenue growth remains broad based.
Relative to cash and longer-duration bonds, short-duration bonds have historically generated better returns during the late phase of the business cycle, but longer-duration bonds generally provide better diversification of portfolio equity risk.
|4.||Asset allocation: The late cycle typically favors inflation-resistant investments|
Late cycles have the most mixed performance of any business cycle phase. Stocks have typically outperformed bonds, and inflation-resistant assets such as commodities, energy stocks, short-duration bonds, and Treasury inflation-protected securities (TIPS) have typically performed relatively well in the late cycle. Combining inflation-resistant assets has increased the frequency of outpacing inflation, a difficult task for cash in today’s low-rate environment. Loss aversion and excessive emphasis on short-term market volatility may tempt investors to make asset allocation changes that deviate from their long-term plans. Investors should create an appropriate mix of investments based on their time horizon, financial situation, and tolerance for risk, and when markets get choppy have a plan for their investments and stick to it. Read Viewpoints: Six strategies for volatile markets.
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