2015 Mid-Year Outlook
All Eyes on Global Monetary Policy
Although underlying fundamentals have not changed significantly, markets this year have been driven by expectations regarding interest rates, currency, international monetary policy and geopolitical risk. We maintain a moderately bullish outlook for the rest of 2015, but we are also mindful of potential issues that could introduce volatility and take us off course from another year of positive returns.
All eyes are currently on the Federal Reserve. When will they begin to raise rates? How much will they raise rates? How quickly, and for how long? Good economic news, which may accelerate the pace of Fed tightening, is being viewed as bad news as such policy movements may stymie growth and dampen market returns. On the positive side, higher yields may reflect expectations for improving economic growth and inflation. On the negative side, through higher lending costs and mortgage rates, higher rates could also threaten our fragile recovery. We believe that much of second half 2015 volatility will likely originate from global monetary policy.
Encouraging strength from the U.S. economy in the second half of 2014 had heightened expectations that the Fed could initiate its first interest rate hike since 2006 as early as this summer, but after harsh winter weather led to a string of disappointing first quarter economic data, expectations for a 2015 rate hike soon diminished. Just as economists began to fret about a broader global economic slowdown, robust job creation and even some bourgeoning evidence of upward pressure on wages began to appear in the second quarter. As a result, the third quarter begins with a realistic possibility of a Fed rate hike by quarter’s end.
Our belief is that the Fed will make a ceremonial interest rate hike in September and then pause to see the reverberations in the economy. However, the last time the Fed raised rates was August 2006. This time around, the Fed is trying to unwind its unconventional quantitative easing program with a more conventional policy. Additionally, the European Central Bank and the Bank of Japan, as well as the other central banks across the world, are engaged in their own versions of quantitative easing.
Looking forward, equity markets have several tailwinds supporting a continuation of the ongoing bull market. U.S. economic data has shown recent improvement, especially from the housing, automotive and labor markets. The economic data out of Europe, particularly Spain, has shown some improvement. And, while equity valuations are no longer cheap in an absolute sense, a case can be made that, relative to current interest rates and inflation, they are not excessive from a historical perspective. While we offer a somewhat optimistic view towards the global economy and equity markets, an early end to European quantitative easing, the strength of the U.S. dollar, and the lack of any sizeable market pullback since mid-2011 are the risks to our prognosis that could elevate financial market volatility.
In the environment that we anticipate – solid equity market tailwinds balanced with real risks – we would not be overly aggressive or overly conservative in equity allocations. We favor domestic equities and have a slight growth bias. While overseas markets are starting to show a solid footing, we would prefer to see more fundamental improvement before making a sizeable shift into foreign equities. In fixed income, we continue to favor below benchmark duration, credit sensitive bonds, and a small international bond allocation as the markets are likely to be dominated by a strong dollar and influenced by elements such as the Greek debt negotiations and Ukraine/Russia sanctions.
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