Six Issues to Watch Now

2016 Midyear Outlook: Six Issues to Watch Now


Story Highlights

  • We encourage investors to avoid overreacting to current market influences.
  • We believe the markets have proven to be resilient during the past decade, despite significant bouts of volatility and ongoing macroeconomic and geopolitical headwinds.

The first half of 2016 provided a choppy ride for investors.

They faced continued concerns about global economic growth, uncertainty about interest rates, slowly rising oil prices and the prospect of a contentious U.S. presidential election. Stock market volatility spiked higher early in the year, fell off at the close of the first quarter and then increased again. We think several of these factors will persist in the near term and have identified six issues to watch for the remainder of the year.

global economic growth

Economic growth still slow

We expect modest economic growth to continue in the global economy in 2016.
Interest Rates

Interest rate uncertainty

The direction and timing of interest rate changes in the U.S. and other countries is unsettling global markets.
Oil Prices

Impact of oil prices

Stock prices are likely to follow unsettled crude oil prices through the remainder of the year.
Market Volatility

Market volatility continues

The roller coaster ride in stocks is not finished and volatility is likely to continue, although we expect moderate positive returns for the year.
Key Stocks

Key stock sectors to consider

Several sectors may offer potential for investors through 2016: Health care, technology, consumer discretionary and real estate.
Presidential Campaign

Looming U.S. presidential race

A contentious campaign is under way; several critical issues that are central to U.S. economic growth will face the next president.

Economic growth still slow

We expect modest economic growth to continue in the global economy in 2016, with a slight slowing from the rates recorded overall in the last two years. The International Monetary Fund’s (IMF) World Economic Outlook in April forecast what it called “modest” global growth for the year of 3.2%, down from its 3.4% estimate in January. Low commodity prices continue to pressure developing countries with economies that depend on commodities exports.

Among the developed markets, we think the U.S. will slow but achieve a better growth rate than the U.K. and the eurozone in general, especially following the U.K.’s “Brexit” vote (see page 4). We also expect Japan’s growth to drop off. Earlier this year, the Bank of Japan (BOJ) introduced negative short-term interest rates to boost inflation. However, the action has resulted in a stronger yen and could impair bank lending going forward.

The U.S. economy still is seen as a safe haven globally and we think it will continue to attract funds from outside the country. While the U.S. economy is growing, it’s doing so at a slow rate. U.S. gross domestic product (GDP) growth in the first quarter this year was reported at the snail’s pace of an annualized 0.5%. That was a slowdown from 1.4% in the final quarter of 2015. However, revisions to U.S. economic data are common and the growth rate in June was revised to 1.1%.

“Based on our analysis, we think second-quarter GDP growth, which will be reported in late July, is tracking at about 2.5%,” says Global Economist Derek Hamilton. The data indicate the U.S. economy still is performing better than most other developed markets. Questions also remain about China’s growth prospects. Its economic data have strengthened recently in response to policy changes to stimulate investment in housing and certain areas within infrastructure. The People’s Bank of China has aggressively added liquidity to the banking system and credit availability has begun to accelerate. Despite what was widely seen as the mistake of 2009 – a credit-driven buildup in manufacturing capacity that caused a dramatic increase in the ratio of debt to GDP – China again is moving down a similar path to reignite growth. Early indicators in China suggest some traction.

Interest rate uncertainty

Speculation began almost immediately about the timing of the next interest rate hike after the Fed in December 2015 raised short-term interest rates by 25 basis points. That marked the first increase in seven years. The Fed has been unclear about the timing of future rate hikes because of what it considers risks to the global economy. Mark Beischel, CFA, Global Director of Fixed Income, says the results of the Brexit vote have raised new questions about whether the Fed will take any action in 2016. In general, Beischel says he expects the Fed’s current approach to mean interest rates “will stay lower, longer.”

The Fed made it clear that it will closely watch U.S. employment and inflation in considering the timing of future rate hikes. But news reports show that all Fed governors don’t agree on the appropriate timing for the next change, so it isn’t a simple matter of watching government reports.

For labor-market data, the Fed focuses on the U.S. Labor Department’s monthly jobs report released the first Friday of every month. The U.S. added more than 160,000 jobs in April and the unemployment rate was unchanged at 5.0% -- within the Fed’s target range. But May’s report threw a curve: Employers added the fewest number of workers since September 2010 and the unemployment rate dropped to 4.7%, the lowest since November 2007. That decline was attributed to workers leaving the labor force.

In judging inflation, the Fed watches the price index for personal consumption expenditures (PCE). This measure is done as “headline” and “core” figures. Headline inflation – usually reported on an annualized basis – is not adjusted for seasonality or for volatile food and energy prices, which are removed from the core data. The headline and core PCE rose 0.9% year over year (y/y) and 1.6% y/y in May, respectively. The Fed has stated that its target for inflation is 2%.

Even with the ongoing uncertainty about interest rates and assuming there is no decline into recession, Beischel says he believes there still are opportunities for investors in high-yield debt securities, emerging-market sovereign bonds and investment-grade corporate debt. There also has been action outside the U.S. affecting interest rates and the markets. As noted, the BOJ moved to a negative interest rate policy that we think will make the country less competitive and have a negative economic effect. In addition, Japan announced in early June that a planned 2017 sales tax increase has been postponed to 2019, which actually supported the yen’s value in global currency markets.

The European Central Bank (ECB) cut interest rates again in March and expanded its quantitative easing (QE) facility, which provided support for the euro. Corporate credit now is part of that QE program. Inflation in Europe generally is stable and the overall economic recovery still is improving.

The U.K. on June 23 voted to leave the European Union (EU) by a 52% to 48% margin. Global markets had been nervous about a “Brexit” and stocks around the world plunged in response to the result. While we think continued volatility is likely in the short term, we believe it is important for investors to keep a long-term view.

The U.K. now must begin formal negotiations to withdraw from the EU – expected to be a difficult two-year process – which should provide more clarity on the ultimate impact. The Brexit vote has added uncertainty about U.K. economic growth, however, and we believe the decision to leave the EU could push the U.K. into recession in the latter half of the year. The U.K. will need to set new trade deals with the EU and the rest of world, resulting in potential losses in exports and investment flows.

Given the shock from Brexit, we also think the Bank of England is increasingly likely to ease policy including cutting interest rates, increasing quantitative easing and providing liquidity.

The Brexit vote highlights rising nationalism globally and sets the stage for the U.K. to establish its own immigration and trade policies. It also could open the door to other countries questioning their membership in the EU and potentially do harm to Europe’s economy overall.

Impact of oil prices

Stocks have followed volatile crude oil prices this year. In early May, the International Energy Agency (IEA) said global energy inventories were likely to continue to rise in the first half of 2016 but would decline dramatically in the second half of the year. The IEA blamed the decline on strong demand and falling supply. Investors have struggled to track supply/demand and its impact on both oil prices and stocks more broadly, and we think that is likely to continue.

An oversupply that peaked at about 2.0% of global production led to the price decline that continues to affect the industry and markets. That oversupply equaled less than 30 minutes of global demand and is a much smaller oversupply than in prior cycles, according to David Ginther, CPA, portfolio manager of Waddell & Reed Advisors Energy Fund and Ivy Energy Fund. The resulting lower prices have caused slower production worldwide. In December 2015, oil output in the continental U.S. fell on a year-over-year basis – a first since the onset of the shale renaissance. We now estimate oil demand will add about 1.0 million barrels per day (bpd) to today’s 95 million bpd. Total U.S. output is 8–9 million bpd, including 3 million from shale, versus consumption of 20 million bpd. However, demand can spike when oil is “cheap.” Demand growth in 2015 was nearly double the historical average, and oil demand continues to rising in emerging markets. In addition, U.S. drivers have taken advantage of cheaper gasoline prices by driving more.

Ginther says slowing production and rising demand will mean a supply/demand balance this year and could drive oil prices higher in coming years. Prices already have rebounded from their lows, with both Brent and West Texas Intermediate crude oil – the market benchmarks – topping $50 per barrel in late May. The U.S. reported a sharp decline in crude oil stocks in May, with inventories down 4.2 million barrels from a record high of 540 million. Expectations for a continued drop in inventories through the summer have helped prices recover, and wildfires in Canada and political problems in Nigeria have trimmed production.

In addition, Iran’s is resuming production but we do not expect Iran to hurt oil prices in the long term. We think Iran will add 500,000 bpd by year end. We project future demand will grow at about the rate Iran will add supply, meaning the world will need Iran’s oil to avoid sudden changes in the global supply/demand picture.

Hamilton notes that the price bounce may also indicate a reduction in headwinds for shale oil producers because they again may find it worthwhile to make capital investments in oil rigs and drilling operations. Despite the potential energy price hike to consumers that follow higher crude oil prices, eliminating that headwind could be mildly beneficial to the U.S. economy, Hamilton says.

Market volatility continues

Concerns about slow economic growth and the direction of interest rates have made investors skittish about any change in economic indicators. That attitude often is exaggerated when it shows up in the stock and bond markets, says Chief Investment Officer Phil Sanders, CFA. Investors are looking for any hint of a slowdown, stronger recovery or clarity on the timing of interest rate changes, he says.

Stock market investors definitely have endured a wild ride in 2016. That ride became even more unsettling when the results of the U.K.’s Brexit vote were announced. The CBOE Volatility Index (VIX) has spiked above 18 – the index’s 10-year average – on 10 occasions in the last 10 months, reaching levels not seen since the European debt crisis in 2012. And from its extreme points this year, the VIX has fallen 53% and subsequently climbed 97%. Overall, the VIX has moved higher or lower by at least 10% in a day a total of 17 times this year.1

We think the issues outlined in our Outlook, along with other market factors, are likely to mean the roller coaster ride is not finished and volatility will continue. That said, we think the U.S. market may retain its relative appeal, with domestically focused stocks likely to get support relative to multinationals because of the added uncertainty of the Brexit vote. We also still expect moderate positive returns in stocks for the year.

We encourage investors to avoid overreacting to current market influences. We believe the markets have proven to be resilient during the past decade, despite significant bouts of volatility and ongoing macroeconomic and geopolitical headwinds.

Key stock sectors to consider

We believe there are a several specific stock sectors that may offer potential for investors through 2016: Health care: Sector valuations have been depressed for an extended period. We think biotechnology companies in particular offer significant potential for profit growth. In developing markets, we think the demand for quality health care should increase with the standard of living. We are paying particular attention to medical technology, biotechnology, medical records and pharmaceuticals, which often are innovators and early adopters of new technology.

Technology: While the “FANG” stocks (Facebook, Amazon, Netflix and Google) have been responsible for much of the gain in the sector, our research is identifying additional companies exploiting innovation to drive growth. We believe many of the stocks in the information technology space remain relatively inexpensive and are well-positioned going forward. Consumer discretionary: U.S. consumer spending rose 1% in April, marking the biggest one-month increase in six years, according to the latest Commerce Department report. Low interest rates, low energy prices and improving wages continue to drive consumer spending, creating additional opportunities.

Real estate: We expect more opportunities as existing publicly traded real estate companies grow, new companies come to market and additional countries develop real estate securities markets. Publicly traded real estate comprised 330 companies and totaled $1.3 trillion at the end of 2015, up more than 20% from the end of 2013.2 Here’s another way to look at it: Public real estate securities comprise less than 8% of the total value of investable real estate around the globe. We think that translates into opportunities for continued long-term expansion.

Sanders says growth stocks are likely to continue to lead the market in the mid to long term. “In the short term, we think value stocks may continue to outperform,” Sanders says. “However, many value stocks are priced for significant economic distress, especially if their revenues are exposed to global commodity market tends. After these distressed valuations improve, we expect the growth stock cycle to resume.”

Looming U.S. presidential race

While neither major party has concluded its nominating process, it appears that presumptive nominees Hillary Clinton for the Democrats and Donald Trump for the Republicans are the likely presidential candidates.

Several key issues remain central to the growth of the U.S. economy and we think they will be critical topics for the next president.

Disappointing growth in domestic demand during the latest economic recovery has been the result of a variety of factors, including the country’s demographics, the debt overhang, residual effects from the global financial crisis and weak external demand. We summarize these issues as Demand, Demographics and Debt:

  • Demand: Domestic demand is something that the government can directly impact. We believe the federal government will need to walk a fine line between productive investments and spending that boosts demand in the short term but hinders demand in the future. This is especially true given the federal government’s high level of debt.
  • Demographics: Many developed countries are experiencing population declines, while the U.S. population is expected to continue to grow. Even so, the aging U.S. population will put pressure on federal spending. We think it is likely to mean a combination of entitlement cuts and tax increases.
  • Debt: Private debt has fallen since the global financial crisis, but it is still relatively high versus historical levels. That debt is likely to be constraining economic activity. A high level of government debt also could have a dampening effect on private demand as consumers and businesses assume that taxes could rise in the future or benefits could be cut.

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Associated Tags: Market Perspectives, Strategies

1Source: FactSet data as of 06/27/2016.

2 Based on FTSE EPRA/NAREIT Developed Market Index

Past performance is not a guarantee of future results. The opinions expressed are those of Waddell & Reed Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 15, 2016, are subject to change based on market conditions or other factors, and no forecasts can be guaranteed. The information is being provided as a general source of information and is not intended as a recommendation to purchase, sell or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Diversification does not guarantee a profit or protect against loss in a declining market. It is a method to manage risk.

The S&P 500 Index is composed of 500 selected common stocks chosen for market size, liquidity, and industry grouping, among other factors. The FTSE EPRA/ NAREIT Developed Index tracks the performance of listed real estate companies and REITs worldwide. It is not possible to invest directly in an index.

Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of a fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These and other risks are more fully described in a fund’s prospectus.

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