Quarterly check-in: insight on market risks

Despite issues in the U.K. and Europe, the backdrop for the U.S. stock market is reasonably constructive.

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At the end of the second quarter, the British vote to leave the European Union triggered a major bout of global market volatility. The big problem, as I see it, is the political and economic uncertainty that Brexit interjected into the markets. The near-term cyclical impact will likely be felt most acutely in the U.K. because it’s highly dependent on Europe as a market for its exports and financial services. For the U.K., this uncertainty is likely to depress business sentiment and freeze new investments and maybe hiring, and could even lead to recession.

A major market impact of the Brexit vote has been to drive sovereign bond yields even lower across the entire world. Brexit has reinforced concerns many investors have about global economic weakness, and led many to a search for greater safety. It also has likely convinced monetary policymakers to maintain even easier stances than before. In the U.S., this means the market no longer expects the Federal Reserve to raise interest rates soon. For Europe and Japan, negative policy rates could be pushed even lower. The net result that we’re starting to see is the playing out of some unintended consequences of these ultra-low and negative ratesthat includes that bank shares have plunged in recent months, particularly in Europe and Japan. All this makes the outlook even more challenging.

Over the longer term, Brexit is the most visible and tangible sign so far that globalization has come under heavy political pressure. For more than two decades, we’ve seen rapid global integration that has spurred the cross-border flow of trade, of capital, and of labor. But global trade has flattened in recent years, and more worrisome is that economic openness is under political fire in many countries–including the U.S.

So, when we think about how all these risks affect the current outlook for asset allocation, we go back to our business-cycle framework. Overall, the risks are higher for the global economy, because the outlook for the U.K. and Europe has worsened. However, the world’s two largest economies–the U.S. and China–remain relatively stable in the near term. So, over the course of the next year, we still believe that gradual stabilization is the most likely scenario for the global economy.

In the U.S., the risk of recession remains low in large part due to the health of the household sector. Even with the slower pace of job growth that we’ve seen recently, the labor markets have continued to tighten, and this is slowly pushing up wage gains. Consumers now are enjoying some of the best inflation-adjusted income growth that they’ve seen in nearly a decade.

When we put this all together, we think the backdrop for the markets is still reasonably constructive. However, we do anticipate elevated market volatility may be around for a while, and this means a well-diversified portfolio may be more important than ever.

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