U.S. equities: The market benefits from moderate economic improvementFor U.S. equity investors, the second quarter offered a number of familiar themes: relatively low market volatility, new record highs for major indexes, and a modest advance for stocks. Along with these positive trends, however, came a decidedly lower level of optimism about progress from Washington in implementing pro-growth, business-friendly policies. Mounting concerns and increased media focus on political controversies stalled initiatives in Congress and contributed to two brief, broad-based market declines.
Heightened uncertainty in Washington remains a key risk for equities. In our view, however, a number of favorable trends remain in place and are likely to keep politics from derailing market momentum. Corporate earnings strength may be the most potent positive force. Investors have shown an impressive ability to look beyond headline distractions and focus on healthy fundamentals and stronger-than-expected financial results from many U.S. businesses. And, despite a backdrop of political drama, many areas of the economy have been quite uneventful — a scenario that we believe could continue to fuel the market. Along with a slow and steady advance for equities, we have seen moderate improvements in wage growth, employment, consumer confidence, and consumer spending. While moderate changes may not generate headlines, they tend to bode well for stock market performance and investor sentiment.
A deliberate, communicative, and fairly predictable Fed has also helped maintain calm in the market. However, we see potential risks for equities in the context of Fed policy. While the three interest-rate hikes since December were widely expected, much less certain is the effect on markets when the Fed begins the process of shrinking its balance sheet. Investors have become quite accustomed to the Fed's accommodation, but we are in unprecedented territory as the Fed works to reduce a balance sheet of more than $4 trillion.
Non-U.S. equities: European political risk falls and non-commodity emerging markets strengthenLooking ahead to the second half of 2017, we think the disappointments of U.S. policy change will become increasingly less relevant to the markets. Against a backdrop of stalled legislation, we expect international markets will remain attractive for investors, both for their distance from U.S.-based uncertainties and for what we consider their compelling fundamentals and valuation profiles.
In the second quarter, all eyes were on the unfolding political situation in France, where the general election promised to deliver either a stunning blow to EU institutions or a resounding victory for foundational EU principles. With far-right French presidential candidate Marine Le Pen vanquished by political centrist Emmanuel Macron, European markets have risen on the improved prospects for a more unified European Union and the promise of economic reforms in France.
As France and much of Europe benefit from the macroeconomic bounce, including stronger industrial production and employment indicators, we see relatively fertile ground for adding to select equity positions. This situation is quite unlike the United States, where we see more classic signs of late-cycle economic conditions: Consumer credit is slowing while delinquencies are rising, auto sales are depressed, the labor market is near full employment, and policymakers are tightening interest rates. In Europe, therefore, where we prefer to focus on stock-specific stories that exhibit promising catalysts for change, we think the lagging nature of Europe's cyclical recovery relative to the United States enhances the potential of European equities to perform well.
We anticipate that the strength in non-commodity-exposed emerging markets — such as India, South Korea, Taiwan, and Argentina — may continue, if certain conditions remain in place. Generally speaking, the U.S. dollar's relative stasis can give some breathing room to emerging-market stocks, as can relatively low developedmarket interest rates. Despite higher risks, we believe yield-seeking investors will continue to pour money into both the equity and debt markets of the world's emerging economies if the currency, interest-rate, and policy backdrop remains supportive.
Economic stability in China is the consensus expectation, at least until its next political transition during the 19th National Congress of the Communist Party of China this fall. The expectation of stability is based on policymaker's willingness to supply continued stimulus to the Chinese economy. But we expect volatility to be a rising risk in China and in countries and markets that are tied to China's economic fortunes.