Investing in Range-Bound Markets
Global markets experienced a volatile first quarter. Weak economic data in January stoked recessionary fears and sent equity markets sharply lower during the early part of the quarter. However, some stabilization in economic data and mounting evidence of a rapidly tightening U.S. labor market helped drive a broad-based market rally that began in mid-February. Arguably, some of the equity market’s newfound strength was based on the perception that the economy is likely strong enough to avoid recession but not too strong to force the U.S. Federal Reserve (Fed) to raise interest rates faster than the consensus expects. Looking ahead, our view is that crosscurrents will keep global equity markets largely range-bound (not sharply higher or lower) for much of this year.
The financial markets are facing a multitude of crosscurrents – tailwinds likely to limit significant market weakness and headwinds likely to limit significant market strength. On the positive side, probably the most significant market tailwind is stable and improving economic data. Since the end of the Great Recession, we have witnessed steadily improving labor and housing markets. They have been recently augmented by improving manufacturing data, a pickup in consumer spending, and signs of rising wage growth. As witnessed by investor reaction in the first quarter, economic data plays an important role in determining market direction. Other tailwinds include the Fed being cautious about further raising interest rates and central banks in Europe and Japan using monetary policy to improve their economies.
Since it is possible that much of the improving economy has already been factored in by investors, the current market valuation is a significant headwind that we are watching very closely. The 12-month forward price-to-earnings (P/E) ratio of the S&P 500 is well above its 10-year average. Regarding the "price" of the P/E ratio, the bull market that began in March of 2009 has led to a nearly 7 year appreciation in stock prices. With respect to the "earnings" of the P/E ratio, the consensus expectation is the S&P 500 will experience a decline in earnings growth for a fourth consecutive quarter. This combination has led to stretched valuations of U.S. stocks, which signals the market may be overvalued relative to earnings. Other potential headwinds include further weakening of economic growth in China and unexpected inflation that might cause the Fed to raise interest rates faster-than-expected.
We believe the current secular bull market should continue, albeit with more measured gains. Considering slower global growth projections and current market valuations in general, we would expect long-term returns in stocks and bonds to be below average, accompanied by higher volatility. Globally, central bank stimulus should provide support to financial markets and backstop against any type of major bear market selloff. We expect equities to trade within a range, though we still see more upside potential from current levels. We also feel that companies that are able to grow, despite an anemic economic backdrop, are likely to command a premium and therefore continue to favor growth over value across the market cap spectrum. From a global perspective, we still favor domestic equities. However, opportunities in international developed markets have increased with more accommodative central bank policies in Europe and Japan, coupled with more attractive valuations and being in earlier stages of economic recovery.
Within fixed income, we continue to maintain a somewhat defensive position, with duration slightly below the benchmark, and a solid allocation to credit sensitive and high yield bonds. With the expectation that interest rates may remain lower for a longer period, due to a lack of inflation and only a modest economic growth environment, we have lowered our long-term range of expectations for bond yields. As we bounce off the bottom of this new range, we will likely begin reducing our defensive positioning. Lastly, to mitigate unforeseen volatility in an increasingly uncertain environment, we believe it prudent to retain an allocation to alternative investments that have low correlations to traditional investments.
Please see the Market Outlook Second Quarter Market Outlook for additional insight.
This report is created by Cetera Investment Management LLC
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Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards. A High Yield Fund yield is high due, in part, to the volatility and risk of the high securities market. High yield funds are also known as "junk bonds." While diversification may help reduce volatility and risk, it does not guarantee future performance.
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