Eye on the Markets - 2017

Market Challenges and Global Outlooks

By Ketu Desai

Seasonally, this is a challenging time for the market. In such periods, it is helpful to examine the bearish and bullish arguments for the market. In this article, we do just that and also take a look back at recent activity and then look forward.

While the market has lacked clear direction in recent weeks, volatility has picked up. In fact, at points, 40 percent of the S&P was down 10 percent or more from their 52-week high, including large tech stocks such as Amazon and Netflix. The recent volatility has led many investors to risk-off assets, while gold has had a nice rally, as have Treasury bonds.

The market has lacked clear direction because market participants have been balancing bearish and bullish arguments. On the bear side, geopolitical risks have come to the forefront as North Korea continues to be a destabilizing force. Valuation and the length of this bull market remain a hurdle for many bearish investors. While valuation is elevated relative to historical measures, it is also important to note when making such comparisons to keep in mind the interest rates and inflation environment. Interestingly, the trailing P/E for the S&P is more than one turn lower than it was a year-ago, and the forward is approximately the same.

Bears are also concerned about the political climate and the ability of the administration to get moving on its agenda. While the Fed has communicated its plans to reduce its balance sheet, it is a risk, given that it is unprecedented. The bears would also argue the market is losing steam. A good example of that is, according to Factset, companies that reported positive earnings surprises for Q2 have been down 0.3 percent on average. Historically, earnings beats have resulted in a 1.4 percent gain.

On the bull side, the argument starts with economic fundamentals and corporate earnings. For the first time in a decade, the world's major economies are growing in sync. All 45 countries tracked by the OECD are on track to grow this year, and 33 of them are poised to accelerate from a year ago, according to the OECD.

The German GDP is on pace to grow faster than two percent for the first time in years. Eurozone unemployment is at an eight-year low. Japan's economy grew at an annualized pace of 4 percent in the second quarter. Even countries like Brazil are turning it around.

Brazil coming out of its deepest recession in its history, is now forecast to expand 0.3 percent this year, and two percent in 2018. A rebound in commodities such as iron ore and copper are helping many emerging market nations. The IMF's global price index for all commodities is up 27 percent from the start of 2016. Much of the rebound in commodities is driven by China.

The IMF in July raised 2017 and 2018 growth estimates for China, citing strong credit growth and fiscal support. It also increased euro-area growth projections, highlighting diminished political risks. The IMF expects the global economy to grow 3.5 percent this year and 3.6 percent in 2018, up from 3.2 percent growth in 2016. The three other periods in the past 50 years with synchronized growth saw the trend continue for a few years.

While growth is not spectacular domestically, it is stable at around 2 percent. Recent figures such as services PMI and retail sales are encouraging that growth could accelerate a bit more in the third and fourth quarter.

The Atlanta Fed GDPNow is tracking 3 percent growth in the third quarter, and second quarter growth got revised up to 3 percent. Consumer confidence is near the highest levels since 2000, behind low unemployment, stable inflation, and increasing home values.

Earnings remain strong, according to Factset, earnings grew 10.2 percent in the second quarter and are expected to grow 5 percent in the third quarter. Bulls would also argue that equities are more attractive relative to bonds, as equities earn 2.24 percent greater than bonds versus a historical average 0.61 percent.

Finally, bulls would argue that many of the world's largest investors such as Norway's sovereign-wealth fund and Japan Post Bank are increasing allocation to equities, providing support and a lift to equities.

The continued volatility should remain. We should have plenty of action with the Federal Reserve expected to start its balance sheet reduction and political debate over the tax reform and other agenda items. The outcome to these events will help bulls and bears settle the argument for the reminder of the year.