Doll is chief equity strategist and senior portfolio manager at Nuveen and has been issuing semiannual investment outlook reports for decades. His predictions for the first half of 2014 included broader and stronger—but still moderate—economic growth in the U.S. and globally (See “Bob Doll Gazes into Crystal Ball for 2014”). He has now updated that prediction to be somewhat more positive, but warns that some systemic risk still persists.
For those keeping score, Doll says in his mid-year outlook report that he got four of 10 predictions right so far in 2014, with four predictions still being too close to call and two going the other way.
In short, Doll believes that volatility should rise in the months ahead, but that equities can still make gains with U.S. economic growth in the process of broadening and deepening. “There are signs that economic growth has begun to accelerate,” Doll says. “Household net worth is improving, corporations are spending more money and even the deficit is shrinking faster than expected.”
Also, jobs appear to be coming back to the U.S., especially in the manufacturing and energy sectors, and employment, by some measures, is now at a new all-time high. While the pace of jobs growth has been uneven during the recovery—and the labor force participation rate has been struggling—it is impossible to deny that there are more jobs today than there were at the prior peak in 2007, Doll says.
Doll believes corporate earnings growth should accelerate, but he says near-term risks may rise as volatility picks up due to losses in liquidity arising from the slow-but-steady tapering of the Federal Reserve’s bond buying programs. From a positioning perspective, Doll notes that the primary investment theme is a focus on free cash flow, which provides companies with the ability to be flexible, to invest in their businesses and to focus on long-term strategic planning.
“To be sure, healing is a process, not an event, but there is no denying that it is happening,” Doll says.
Doll says he is consistently fielding questions about inflation risks. “Is inflation becoming an issue? Not yet, but it bears watching,” Doll admits. He says some investment managers are concerned that the Consumer Price Index has moved up to the 2% annualized level.
“Inflation is certainly higher than where it has been over the course of the post-recession period,” Doll explains. “But weak wage growth and plenty of scope for employment to improve should keep non-commodity inflation under control.”
In fact, slightly higher inflation seems to be a sweet spot for equities, Doll says. “Lower inflation could spark deflation worries, but higher inflation could prompt Fed overreaction,” he adds. “Our best guess is that inflation is more likely to rise than fall in the coming months, which may cause a scare down the road. At current levels, however, we would not cite inflation as a concern.”
Doll notes that stocks’ winning ways have persisted so far in 2014, with U.S. markets hitting record highs as equities notched their sixth consecutive quarter of positive returns. Investors responded positively to solid economic news and improving corporate earnings results, Doll explains.
The rise in merger and acquisition activity and other equity-friendly corporate actions also helped markets, Doll says. U.S. markets generally outperformed other developed markets, while emerging markets experienced strong results. From a sector perspective, all areas of the market saw positive performance for the more recent quarter, with energy leading the way. Bonds also experienced decent results, Doll says, with the Barclays U.S. Aggregate Index up 2% for the second quarter and 3.9% for the year, and the Barclays Municipal Bond Index up 2.6% and 6% over the same time periods. Cash, meanwhile, continues to produce returns that are only fractionally over 0.
One of the most important market stories has to do with historically low levels of volatility, Doll says. The VIX Index (often referred to as the “fear gauge”) ended the quarter at 11.6, well below its historic average of just over 20.3. Generally good economic and corporate data along with high levels of liquidity coming from central banks have allowed markets to become eerily calm, Doll suggests.
In terms of risks moving into the remainder of the year, Doll says investors’ fears that the Federal Reserve is being too dovish about rising inflation and falling volatility may turn out to be well founded. Tapering is continuing, Doll explains, with the pace of bond purchase reductions being well telegraphed. And the Fed has repeatedly stated that it intends to keep the Fed funds rate anchored near zero for the foreseeable future.
“We believe the Fed may be underestimating the strength of the economy, the pace of jobs growth and, most critically, the possibility of higher inflation,” Doll says, despite other statements predicting inflation will remain under control. “Additionally, the Fed’s actions and behavior have helped push volatility levels lower. Low volatility encourages risk taking by both investors, who have not experienced a 10% market correction in 32 months, and by companies, which have been ramping up leverage on balance sheets.”
At this point, it is fair to wonder whether the Fed is in danger of falling behind the curve, Doll says. He predicts bond yields should rise, but not enough to disrupt equities' ongoing day in the sun. The yield on the 10-year Treasury began the year at 3%, dropped to a low of 2.4% at the end of May and ended the second quarter slightly higher at 2.5%.
“Given that we expect economic growth to accelerate, we believe bond yields are likely to rise,” he says. “If yields were to rise quickly and dramatically, that could unnerve investors and cause a downturn in equity prices. But we believe equity markets will be able to remain resilient if and when yields start to advance, and we would only become concerned after yields have moved quite a bit higher.”