Midyear market research updates from Bank of America Merrill Lynch and Prudential both forecast optimistic outlooks for the second half. Both institutions say reduced political brinksmanship in the U.S. and the slow-but-steady abatement of global macroeconomic headwinds spell favorable conditions for growth in the months ahead. Bank of America Merrill Lynch researchers expect the S&P 500 Index to close the year around 2,000 or higher, while Prudential says global returns are edging upwards, on the heels of softer global growth in the previous year. The outlook for the rest of the year is brightening, Prudential says, and real estate markets are following suit.
Ethan Harris, co-head of global economics research for BofA Merrill Lynch, says global markets are likely to remain relatively volatile, but the global theme entering July is “finally out of rehab.” The global economy is showing signs that it has recovered enough from the shock of 2008 and 2009 to grow on its own again, Harris explains, which turn has led the Federal Reserve to continue scaling back its quantitative easing (QE) program.
But David Woo, head of global rates and currencies research for BofA Merrill Lynch, observes that recent surges in bond-buying activity in places like China and Belgium have essentially picked up any slack left by the Fed’s reduced bond buying. It’s a complicated story, Woo says, but increased foreign government bond buying has had the puzzling impact of helping to keep interest rates low, even as U.S. equity markets set record highs. There is still some question about what could happen to growth and the inflation outlook if and when government bond buying slows, Woo says.
Overall, BofA Merrill Lynch is skeptical on the premise that inflation will accelerate in the near term, Harris says. “Inflation is something we need to pay close attention to,” he adds, “but the global backdrop for an uncontrolled inflation spike isn’t there. Inflation is low almost everywhere you look. In the Eurozone they are actually facing the risk of deflation.”
Harris warns investors that there is a lot of noise and speculation around what the Fed is doing currently and what it may do in the future, so it’s important not to lose sight of Chair Janet Yellen’s written guidance. Harris says Yellen has been reassuringly consistent in her explanation of Fed policy and its effort to drive fuller employment.
QE Lives On
“The main message is that they will keep doing QE till at least the end of the year,” Harris says. “The Fed will continue tip-toeing, and we expect a small interest rate hike in late 2015 at the earliest. This will eventually cause some upward pressure for bond holders but it will not be a disaster if it’s a slow and steady increase that can be managed.”
The global outlook for equity investments remains positive, explains Savita Subramanian, head of U.S. equity and quantitative strategy for BofA Merrill Lynch. She says investors should consider over-weighting equity portfolios in the energy, technology and industrial sectors. These sectors are globally exposed and global gross domestic product-sensitive, Subramanian explains, meaning they should perform well as the global markets pick up steam. Sectors to underweight include consumer discretionary, which could underperform without pickups in employment or wages, as well as utilities and telecommunications, which have characteristics similar to bond investments.
Subramanian says that nine of the 15 indicators used by her firm to assess equity valuations show global markets are trading at cheaper-than-historic levels, suggesting there is upside opportunity for equities—especially with emerging squeamishness and uncertainty in the bond markets.
But for retirement investors looking for an inflation hedge that pays in the remainder of 2014, Francisco Blanch, head of commodities and derivatives research for BofA Merrill Lynch, says investors should look to commodities. Yields in commodity investments have picked up substantially so far this year he says, and the asset class is currently returning as much as high-yield debt.
“You’re being paid to own commodities right now,” Blanch explains. “Global growth is picking up and that’s a positive driver for commodity prices. And another driver is that supplies are tightening. Whether its aluminum or oil, the supply side is getting tighter across commodities.”Prudential’s 2014 Midyear Global Markets & Economic Outlook briefing in New York City took a broad view of the global economy and new opportunities in emerging markets. At the portfolio level, Ed Keon, managing director and portfolio manager for Quantitative Management Associates, says they’ve made some changes at the margins over the past month or two. Prudential has pulled back a bit on stocks from its previous aggressive positions and switched out some equity positions. They’ve edged away slightly from Europe and added to holdings in emerging markets.
Emerging Markets Re-Emerge
Notwithstanding the resurgence of violence in Iraq, things seem calmer on the geopolitical front according to Keon. Globally, two factors driving returns are growing vigor in Europe and the U.S., Prudential’s biggest overweight markets. “Europe looks the cheapest, and the U.S. looks more like a growth stock,” he says. Emerging markets are also somewhat more cheaply valued compared with their normal levels and cheaper than other market segments, he adds, making them a slightly better growth prospect.
Earnings expectations for emerging markets have risen a bit after a pretty steep fall in the last few years, Keon says, and they have re-emerged as a diversifying asset class. Prudential is not aggressively overweighting in emerging markets, but Keon says they now feel better about the sector than they have for the last couple of years.
Keon is confident about the economic growth outlook in the U.S., as evidence of increases in investment spending has started coming in and the economy is pulling away from sources of fiscal drag. While consumption was weak in the first quarter, it grew well in the second, and the employment market is rallying.
While the economy is very important to the markets, the more immediate impact on the market is earnings, Keon says. “This year, earnings expectations for the U.S. are actually rising,” he says, which is unusual. “Most of the time analysts are an optimistic lot. They start the year off high, and they cut their forecasts as the year goes on.”
But the numbers have actually gone up as the year has gone on, Keon points out, noting that despite a weak GDP he thinks the country will see earnings growth and a potential total return of 10% for this year, including a 2% dividend yield. “After last year, expectations in the long run could be somewhere around 7% to 9%. I think we’ll do a little better than that this year, and maybe a little better next year.”