Smooth Sailing for Stocks?

by Liz Ann Sonders, Brad Sorensen, Jeffrey Kleintop, Charles Schwab and Company

Key Points

• Stocks have been drifting along near record highs and background conditions remain relatively positive in the near term. But seasonal tendencies remain a risk and volatility has picked up a bit, so investors should be on alert for a summer pullback.
• The U.S. economy continues to glide along, with subdued inflation, providing what typically has been a good environment for stocks. Bond yields have ticked higher and some commodities have recovered, but it’s too early to say that the reflation story is regaining credence.
• Economic growth around the world has been improved and stock markets have gained but international outperformance is largely attributable to dollar weakness.

Stocks sail along

Summer is a time when some investors may put their portfolios on the back burner and head out on the sailing boat for some fun in the sun. Conditions for stocks appear to be relatively smooth, illustrated by still-low volatility and major indexes near record highs. We believe stocks will move generally higher, supported by solid earnings, low inflation, and a modestly growing U.S. economy, and we certainly don't begrudge investors taking a little rest and relaxation. But below the surface there are developments to heed, including ongoing geopolitical and monetary policy uncertainties. Keeping a diversified portfolio is important, as is periodic rebalancing, as a geopolitical blowup, a monetary policy "mistake," or a major political shakeup could occur with limited warning signs.

As noted, volatility—albeit still low historically—has ticked higher; while sector rotation has been the name of the game lately. Technology and energy stocks have moved lower over the past month, while financials and health care have rallied—again illustrating why paying attention to the makeup of your portfolio, and being mindful of diversification, can be important (and we provide analysis of all 11 sectors in Sector Views).

This rotation, as well as occasional modest pullbacks in the overall indices, appears to be keeping investor sentiment from getting overly optimistic. This two-steps-forward-one-step-back movement is what we believe will help to extend the long-running bull market and, for now, help prevent a "melt-up" scenario. As good as they feel while they're in motion, they don’t tend to end well.

Economic growth more like a pontoon boat than a speed boat

Earnings are about to come back into focus as second quarter reporting season is kicking off. Expectations are elevated and we believe the recent move higher in stocks has been largely fueled by a solid earnings picture. While in waiting for earnings announcement, economic data has been mostly positive and indicative of an ongoing expansion—albeit a mature one. Investors may be hoping for more of a speed boat look to economic growth, but we believe that pontoon speed, while not exciting, is likely to be more beneficial to keeping the bull market going. Modest growth helps to keep inflation in check, monetary policy fairly loose. There has been a weakening in some "soft" data as surveys and business/consumer confidence have been playing a little catch-down to more subdued "hard" data, which is typically how wide soft/hard data divergences are corrected. We would expect that narrowing to continue if the Trump administration's pro-growth policy proposals continued to get pushed out in time.

Small business confidence has flattened out, but remains high

Source: FactSet, Natl. Federation of Independent Business. As of July 3, 2017.

As does consumer confidence

Source: FactSet, Conference Board. As of July 3, 2017.

While manufacturers remain relatively optimistic

Source: FactSet, Institute for Supply Management. As of July 3, 2017.

As does the service side

Source: FactSet, Institute for Supply Management. As of July 6, 2017.

The hard data continues to provide a mixed picture with the labor market continuing to look strong. The Labor Department reported that 222,000 jobs were added in June, surprising on the upside, while the unemployment rate ticked slightly higher to 4.4%, although wage growth remained modest as average hourly earnings posted a 2.5% year-over-year gain. But the recent durable goods orders report from the U.S. Census Bureau was soft, falling 1.1%, while nondefense capital goods orders ex-aircraft—a proxy for more sustainable capital spending—fell 0.2%. Additionally, the Census Bureau’s retail sales reading was surprisingly soft given the still-healthy labor market, with sales falling 0.3% in May and being flat month-over-month ex-autos and gas.

That said, the important Index of Leading Economic Indicators, put out by the Conference Board, continues to indicate further economic expansion. As you can see in the chart below, this set of indicators is giving no sign of growing recession risk.

Economic growth seems set to continue

Source: FactSet, U.S. Conference Board. As of July 3, 2017.

Can the Fed successfully navigate these waters?

This mixed economic picture, combined with the recent retreat in some inflation measures, has raised the level of uncertainty regarding future Federal Reserve actions. The Fed is intent on continuing the normalization process, with balance sheet reduction gaining a share of the spotlight from rate hikes. Interestingly, some foreign central banks may have aided the Fed in its campaign with more hawkish commentary recently from the heads of both the European Central Bank (ECB) and the Bank of England (BoE) helping to push U.S. Treasury yields modestly higher, which can also be seen in the "benchmark" rate in Europe—the German 10-year Bund.

Yields have ticked higher

Source: FactSet. As of July 3, 2017.

Combine the move in yields with a modest rebound in some commodities such as iron ore and copper may have folks wondering in the reflation story is again gaining traction. We believe it's too early to buy into that, especially with inflation readings remaining low, but it is something to keep an eye on, and could potentially add some more choppiness to the waters as we sail through the summer months.

Broad economic growth

But up until now the global economy is having one of its best years in more than half a decade. All of the world’s top 20 economies are growing so far this year, a broadening of growth we haven't seen since 2010, and that is boosting growth in emerging market economies as they export more.

All of the world’s top 20 economies on track to grow in 2017

Source: Charles Schwab, International Monetary Fund World Economic Outlook April 2017.

Receding risks to growth

Another positive for the market is that the populist political and trade risks that loomed at the beginning of the year have mostly faded as protectionist rhetoric has cooled and European election outcomes eased worries over a breakup of the Eurozone. Most encouragingly, world trade is on track to post the best growth since 2010 as we head into the second half of the year. This is important since the companies in the MSCI AC World Index get more than half of their revenues from international trade.

International stock outperformance

Better economic growth isn't why international developed market stocks outperformed U.S. stocks in the first half of the year. Instead that has been due to the weaker dollar—where politics have had an impact on markets this year. The drop in the dollar in the first half of the year boosted the MSCI EAFE Index by 5%. If we strip out the gains from the drop in the dollar and look at relative performance in local currencies, international stocks actually lagged U.S. stocks despite better economic growth.

Global stocks may continue to rise in the second half of the year as long as earnings growth continues—although periods of pullbacks are expected and healthy in a long-term bull market. This outlook is supported by broad global economic growth and receding political risks. However, a stable to higher dollar could pose a risk to sustaining international stock outperformance relative to U.S. stocks. Read more in the global Mid-Year Outlook.

So what?

The environment for U.S. and global stocks continues to be in decent shape, but some risks are elevated and the possibility of a pullback exists. A notable potential driver of bouts of volatility could be U.S. and global central bank policy as they sail toward monetary policy normalization.

Important Disclosures

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The NFIB small business optimism index is compiled from a survey that is conducted each month by the National Federation of Independent Business (NFIB) of its members.

The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Institute for Supply Management (ISM) Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms by the Institute of Supply Management. The ISM Non-manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

Composite Index of 10 leading Indicators is an index that is a composite average of ten leading indicators in the US complied by the Conference Board. It is designed to signal peaks and troughs in the business cycle, generally known as the leading economic index (LEI). Components of the LEI include average weekly manufacturing hours, average weekly initial claims, new orders for consumer goods and non-defense capital goods, building permits and stock prices. Other components are indexes of supplier deliveries and consumer expectations, M2 money supply and the interest rate spread between 10-year Treasury bonds and federal funds.

MSCI AC World Index is market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International, and is comprised of stocks from both developed and emerging markets.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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