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U.S. Economy SLUGish; Brexit Shock Lingers: Schwab’s Sonders

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According to the Schwab 2016 Midyear Market Outlook, investors and their financial advisors should be preparing for change.

“The second half of 2016 is likely to see changes in the political landscape, monetary policy and market trends,” the outlook states. “Donald Trump and Hillary Clinton are set to face off for the U.S. presidency and their respective policy proposals and a contentious campaign season may contribute to market volatility as the election nears. Adding to the turmoil is Britain’s vote to leave the European Union.”

Schwab predicts it may take time for the shock of the Brexit vote to fully work through the economic, financial and political systems, which may also lead the Federal Reserve to hold off on raising interest rates.

“These factors, along with any change in the trajectory of the dollar’s value against other global currencies, may result in a change in the relative performance of various asset classes and sectors,” according to the outlook.

Experts from Schwab each outline their predictions for the U.S. and global markets, as well as fixed income, in the second half of 2016.

U.S. Economy

Schwab experts expect U.S. economic growth to remain sluggish for the second half of 2016.

“The U.S. economy continues to move like a SLUG — with Slow, Lumbering, Unstable Growth,” according to Liz Ann Sonders, chief investment strategist at Schwab. “Every time it seems to take two steps forward, it falters. This phenomenon is not new. There has been a meaningful slowdown in growth every year since the economic expansion began in June 2009, including this year.”

The silver lining is that a sluggish pace of economic growth, accompanied by low interest rates and low inflation, is not an unfavorable backdrop for equities in the longer term, Sonders says.

“This is why we don’t believe a major bear market is likely,” she says.

Sonders predicts that the aftermath of Brexit, along with the “highly contentious” U.S. presidential election, are likely to bring continued bouts of volatility and uncertainty in the second half of the year.

“The Brexit-related hit to financial conditions supports a more dovish Fed and suggests a continuation of the frustrating range-bound and volatile stock market behavior,” Sonders writes.

This volatility and uncertainty – as well as slightly elevated stock market elevations and weak earnings growth – supports the rationale behind Schwab’s continued “neutral” rating on U.S. stocks.

“By ‘neutral’ we mean that investors should remain at their strategic equity allocations while taking advantage of bouts of volatility to consider tactical rebalancing of their portfolios,” according to Sonders.

One of the more positive indicators for the market looking into the second half of the year is investor confidence, Sonders says.

Sonders points to the American Association of Individual Investors survey that recently showed the lowest level of bullish sentiment in more than 10 years, and the highest level of neutral sentiment in more than 13 years.

“Following occurrences like this in the past, the stock market generally had exceptionally strong returns a year later, with a consistent track record,” she writes.

Global Economy

For the second half of 2016, Schwab expects global economic growth to remain weak and uncertainty to linger surrounding the eventual impact of Britain’s decision to leave the Europe Union.

“Recent shocks in the United States, Japan and Europe suggest the negative market impact could linger for months and may heighten the potential for a recession in Europe,” according to Schwab’s outlook.

Jeffrey Kleintop, chief global investment strategist at Schwab, writes that consumer spending and business investment may slow further in the U.K. and Europe in the second half of the year due to the heightened uncertainty.

“However, the fallout may be limited if the Bank of England and European Central Bank can stabilize financial conditions and the U.K. and eurozone economies capitalize on the weakness in their currencies,” he writes.

While it remains to be seen how long it will take for the markets to recover from the Brexit shock, Kleintop points to several other recent market shocks that were short-term in nature.

“These included … the devastating earthquake and related nuclear accident in Japan, the congressional standoff over the U.S. debt ceiling and credit rating downgrade of the United States, and the European debt crisis,” Kleintop writes. “While the stock market losses were sharp and a recession resulted in two of the three shocks, the time stocks took to recover was three to four months.”

Kleintop suggests that short-term focused traders should be prepared for further stock market declines over the next three to six months, similar to past shocks.

Meanwhile, longer-term investors may want to maintain their globally diversified asset allocations intended to weather volatility on the way to longer-term goals, according to Kleintop.

Fixed Income

Returns in every major fixed income asset class are positive for the year so far, but this unusual pattern of performance is unlikely to continue, according to Kathy A. Jones, chief fixed income strategist at Schwab Center for Financial Research.

In the first half of the year, longer-duration bonds have outperformed shorter-duration bonds, and riskier high-yield bonds have outperformed “core” bonds, which include Treasuries, investment-grade corporate bonds and securitized bonds.

“The message from the fixed income markets is mixed,” Jones writes. “Typically, these various types of bonds don’t all perform well at the same time. Long-duration Treasury bonds tend to do well when economic growth is slowing and inflation is declining, while riskier high-yield and emerging market bonds along with [Treasury inflation-protected securities] tend to do well when the economy is in an upswing.”

This behavior is unlikely to continue for the second half of the year though, Jones predicts.

And Britain’s vote to leave the European Union may be a catalyst for a change.

Bond yields have dropped further in major developed countries considered safe havens such as Germany and Japan. Yields in the noncore developed countries such as Spain and Portugal, however, have risen since the vote, according to Jones.

Meanwhile, in the U.S., the likelihood of further rate increases by the Federal Reserve has diminished since the Brexit vote.

If there are no more rate increases this year, Jones anticipates that the yield curve will “flatten as a result of short-term rates holding steady or edging higher while long-term rates remain low.“

“Weak economic growth and deflationary pressures abroad coupled with relatively high rates domestically should mean that U.S. bonds remain in demand by global investors,” Jones writes.

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