The Federal Open Market Committee (FOMC) released its meeting minutes on Wednesday and were more “hawkish” than expected. Hawkish statements lean towards rate hikes whereas dovish statements are more accommodative and against rate hikes. The committee noted that international risks have decreased and that, if the economy continues to improve, a June rate hike remains on the table. This was a bit of a shock the market, which saw the Dow drop 180 points before recovering and finishing the day nearly flat. As we have talked about in the past, we are in fragile territory with these rate hikes. While a rate hike up should signal to the market that the economy is on strong ground (a good sign for stocks), the markets get spooked about it being too soon. The reality is that the market will never be fully “ready” and the Fed just needs to rely on the data and raise rates when they feel the data meets their rate hike criteria. The June meeting is going to be “live”, meaning we will be able to listen rather than wait for the minutes. Overall, the market is seeing a June rate hike at a 34% probability, up 4% over last week.
Rising Wages should boost Consumer Spending:
Disappointing first quarter earnings results from many large retailers have been causing some to question the strength of consumer spending. Economic data from last week, however, showed some positives for the consumer. April’s retail sales figures showed a 1.3% increase, notably higher than the consensus expectations of 0.8%. Likewise, the latest reading of the University of Michigan’s Index of Consumer Sentiment rose from 89 in April to 95.8 in May, its highest level in eleven months.
In our view, these readings help reinforce the notion that the consumer sector remains quite healthy despite some earnings struggles. A possible slowdown in employment growth should be counter-balanced by rising wages. We believe consumer spending remains an important tailwind for the broader economy, which we expect should continue to grow close to 2%.
Outlook for Rest of the Year:
On the positive side, we see the following factors weighing in favor of stocks gaining momentum during the remainder of the year:
- Equity valuations overall do not appear to be stretched and there are many individual companies and sectors that are still trading at historic discounts.
- Earnings improvements should start to materialize in the coming quarters if the pace of economic expansion picks up as we expect.
- The overall negative impact on S&P 500 earnings due to the oil rout appears to be over.
- Investor sentiment may be overreacting to the “noise” in the media relating to the Fed raising interest rates, the EU referendums and China’s debt concerns.
- Corporate tax reform prospects for next year appear bright.
- Consumer and business spending (outside of the oil industry) continue to show strength.
- The record amount of cash sitting on the sidelines could provide the fuel for the next leg of this long term bull market cycle.
On the other hand, the media will stoke fears such as:
- Fear of more trouble for Corporate earnings – especially for energy companies.
- Investors are not convinced that U.S. energy production will keep oil prices lower than normal and help the U.S. economy.
- The market may overreact if the Federal Reserve raises interest rates at any time this year.
- Global economic growth projections remain low for the rest of 2016.
- The referendums in several European Union Countries on exiting the EU could continue to put pressure on the global markets.
- The upcoming U.S. Presidential Election and overall political backdrop is highly uncertain.
- Russia, Iran and other geopolitical risks remain elevated and more conflicts could emerge later this year.
- Regulatory scrutiny over many business and the recent intervention into mergers and acquisitions concerns investors.
Investor Sentiment has weakened in the past few weeks:
A back-and-forth in markets has been the theme that has dominated 2016. Markets pulled back over the past several weeks after rallying from mid-February through mid-April. In retrospect, it shouldn’t be surprising that the market remains choppy. Investor sentiment has remained weak and investors are defensively positioned, continuing to hold large amounts of cash. This suggests investors are still worried about the possibility of a global economic slowdown. It is clear that economic conditions have improved from the start of the year, but investors are unsure if the U.S. economy is going to break out of this “slow growth” mode.
Overall, we think the positives will win out over the negatives, but near-term concerns mean stocks are unlikely to move up in a straight line. The current risks and hurdles include next month’s referendum on whether the U.K. will leave the European Union, the escalation of debt levels in China and the risk that the Federal Reserve takes a more aggressive than expected strategy and raises interest rates too soon. We think the odds are better than not that markets will weather these potential storms. But given the fragile state of investor sentiment, if one of these fears starts to unfold, equities could experience another short term sell-off.
Ultimately, we think the economic data and corporate earnings will continue to produce positive numbers which will help investors feel more confident about moving some of their cash off the sidelines. We expect this evidence will materialize over the coming quarters, which is why we believe equities will outpace bonds and cash over the next six to twelve months. Unfortunately, investors have been slow to embrace good news and are quick to react to any negative headlines. Therefore, the stock market volatility is likely to persist, but we think equity prices will shrug off any short term selling and rise over the next seven months as the economy and corporate earnings continue to show steady progress.
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