Nuveen’s Doll: ‘Risk-on’ resumes as uncertainty subsides

Equity markets rallied last week with the hope of a diplomatic solution to the crisis between Syria and the United States. The S&P 500 advanced 2.03% for the week.1 Broadly, the S&P 500 is in a churning phase after witnessing an all-time high of 1709 on August 2 and then stalling.1 We believe the market has been on hold while waiting for lower oil prices, progress on Syria, further global growth and successful Federal Reserve tapering.

Fed actions influence future
Economic growth is gaining traction yet remains modest. The speed at which bond yields backed up has been unsettling, but a dialing down of the Fed’s accommodative policy equates to a vote of confidence for the economy. We still believe economic and monetary policy will support risk assets.

Current macro themes
The Fed will likely taper the rate of its monthly asset purchases at this week’s FOMC meeting. We anticipate approximately a $10 billion (or somewhat higher) decrease in the rate of U.S. Treasury monthly purchases and no change in purchases of mortgage-backed securities (MBS). Monetary policy will be progrowth as the Fed starts to slow the rate of Treasury purchases. The Fed’s balance sheet should continue expanding until mid-2014.
The latest federal budget data shows a continued improvement in the deficit with year-over-year revenues up 12.6% and spending down 6.7%.2 As a result, the deficit has declined $550 billion since last August, a nearly 50% decline.
The House Republican leadership proposed a plan to fund the U.S. government at current levels until mid-December. The continuing resolution would be accompanied by a related bill that would prohibit funding for the Affordable Care Act. Even if the procedure is not initially successful in satisfying House conservatives, we believe a resolution for government funding at current levels will pass into law before September 30. We expect it will be far more difficult to arrive at a deal to raise the debt ceiling.
2013 is on track to be the worst U.S. bond market in 40 years.3 In contrast, equities have returned approximately 20% year to date.4 Bond prices have fallen since May while equities have stalled. Weak growth and higher bond yields are not a winning combination for equities. We can’t deny the damage of higher yields but see upside risk for our forecast of trend-like growth over the coming year, based on low inventory levels, less drag from fiscal austerity and bank deleveraging and slightly improved confidence.
Emerging markets have begun to rally, and relative equity valuations have compressed significantly compared to developed markets.5 Such valuation levels between emerging markets and the developed world have not been seen since the 2008 financial crisis. Emerging markets do continue to face headwinds. Although a bearish take on China has become the consensus view, credit markets and monetary growth have stabilized.

The big picture
In conclusion, geopolitical tremors from the Middle East and concerns over Fed tapering have heightened investor anxiety and financial market volatility. However, these anxieties seem to be easing. We believe underlying macro fundamentals for the global economy have not been deflected. The global recovery is gradually gaining traction and starting to broaden. Leading economic indicators and purchasing manager surveys continue to rise slowly and point to potentially better growth ahead. There is increasing evidence that the U.S. economic expansion is developing. Around the world, data suggests the Euro area is starting to stabilize, aggressive reflation has shifted Japan to a net contributor to global GDP, and the deceleration in China seems to have ended. Also, global monetary settings will stay supportive.
In our view, the uptrend in the global stock/bond ratio will persist. Investors have just started to reposition out of bonds and into equities. Relative valuations continue to strongly favor equities despite the recent rise in bond yields and forward price/ earnings ratios. We continue to favor economic growth sensitive assets in order to capitalize on our expectations for a strengthening global economy and a shift in investor preferences.

Bob Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management LLC. This commentary originally appeared on the firm’s website.