Analysis on Market Segments and Overall Market Outlook

July 15, 2011

Financial market volatility has remained high as investors weigh cyclical economic indicators against continuing reminders of the post-financial crisis debt hangover. Early this month, the S&P 500 rallied to within 1% of its cycle high as economic data started to improve and interest rates began to rise in reaction. However, news that the U.S. economy added only 18,000 jobs in June stopped the rally in its tracks. While few forecasters have been predicting robust job growth, many are puzzled by the paucity of recent gains.

Global purchasing manager surveys indicate that, while the economy has slowed since February, both the services and manufacturing sectors continue to expand. Some boosts to growth should also appear from improved Japanese industrial production and the beneficial effect of easing commodity prices. Yet signs of economic reacceleration in developed countries are thus far limited. The overhang from global debt burdens, creating uncertainty about future fiscal policy and economic growth, may be an underappreciated suppressant. We think the potential growth outlook for countries grappling with high debt burdens, such as the United States, Japan and certain European nations, will remain constrained through the medium term.

While political maneuvering is in high gear as we go to press, we still expect U.S. politicians to strike a short-term deal to raise the debt ceiling without disrupting financial markets. Major decisions on entitlements and taxes likely won't be resolved until after the 2012 election. The European debt situation is proving more nettlesome. Bond market stresses in peripheral countries have begun to spread to Spain and Italy. Italy scored an "own goal" by botching its annual budget submission, which should have been received positively by the markets but instead raised uncertainties. Thus, the risk of European sovereign credit problems has risen because the number of countries involved has significantly increased. This increases the necessity (and probability) of a more comprehensive solution, including the possibility of a fiscal union and common European bond.

U.S. Equity

  • The valuation of low-quality stocks has returned to longer-term averages
  • A muted recovery isn't conducive to further low-quality outperformance

EAFE and Emerging Markets

  • European shares continue to be dogged by financial concerns
  • Emerging-market stocks should benefit when tightening nears completion

Fixed Income

  • European sovereign weakness endangers European financial institutions
  • U.S. financial institutions have superior balance sheets in relation to their European counterparts

High Yield

  • Recent economic events and light new issues support high yield prices
  • Daily net volume showed a substantial upturn leading into the Greek austerity vote

Global Real Estate

  • Global real estate has mostly tracked the broader global equities index year-to-date
  • Stronger global growth is required for sustained outperformance

Hedge Funds

  • Hedge funds declined 1.2% on average in June, bringing year-to-date performance to 0.8%
  • Managers reduced risk amid uncertainty and expect elevated market volatility to remain

Commodities

  • Chinese corn purchases highlight long-term commodity demand
  • Improved economic outlook needed to rekindle price momentum

Conclusion
Despite strong cross-currents, financial markets have delivered solid returns this year. Major U.S. investment-grade bond indexes were up nearly 3% in the first half, and the S&P 500 gained 6%. (Commodities were the only major asset class with a negative return [–2.6%].) We think this shows that a combination of reasonable global growth, high corporate profitability and easy monetary policy can be a constructive combination for risk taking.

We still face several near-term risks: Even though we expect the European policy makers to expand their efforts to manage their sovereign credit problems, their plan isn't yet clear. We expect the U.S. debt ceiling to be raised, and we want to see that the U.S. economy can grow without further stimulus. 

Analysis on Select Asset Classes

 
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