WIA BELIEVES | Volatility coming, but we don’t have the necessary ingredients for a Bear Market

Commentary from Robert C. Doll, CFA, Senior Portfolio Manager, Chief Equity Strategist, Nuveen Asset Management, LLC

Key Points:

• Equity markets have been in a modest consolidation phase for the last couple of weeks, causing some investors to wonder whether we are heading for a more significant pullback.
• We think volatility may pick up, but also believe this bull market should persist, due to improving global economic growth and solid corporate earnings.
• Stock prices fell early in the week, but the pullback failed to gain much traction. Global equity markets were mixed, with the S&P 500 Index down a small fraction.¹ The consumer and telecommunications sectors performed best, while energy and industrials lagged.¹ 
• Market sentiment has grown less positive in recent weeks, with investors more concerned about tax policy, fuller valuations and a sense of complacency. From a fundamental perspective, investors are also becoming worried about the flattening yield curve and high yield market weakness, which tend to be bearish signals for equities.
• But we think the two most important drivers of equity markets — corporate earnings and real growth levels — still support a risk-on investment stance.

Weekly Top Themes

1. Congress is making progress on tax reform, but the outlook remains uncertain. The House of Representatives passed its bill on Thursday, while the Senate is expected to vote on its legislation the week after Thanksgiving. The bills have some significant differences, and the Senate version includes a repeal of the Affordable Care Act’s individual mandate, which could complicate matters.
2. Stronger and more synchronous global growth should continue to support equity markets in 2018, while also driving inflation modestly higher. Global growth levels and growth expectations are moving higher around the world. The eurozone is strengthening notably and is well past its recent recession. China appears to have successfully transitioned to an environment of less robust but more sustainable economic growth. And U.S. economic data is featuring some of its best readings in years, including an annualized nominal growth rate of 5.1% reported in the third quarter,² a September reading for the ISM Purchasing Managers Index of 60.8³ and unemployment reaching a 17-year low of 4.1% in October.⁴
3. Equity market volatility is being suppressed by long-term structural factors. First, the U.S. economy is undergoing important structural changes, including improvements in inventory management and a shift from manufacturing to the less volatile service sectors. Second, monetary policy has become increasingly transparent and predictable. And third, markets have been subject to fewer and more contained exogenous shocks compared to earlier in the economic and market cycle.

What Would it Take to End This Bull Market?

Over the last couple of weeks, most risk assets (including equities and high yield corporate bonds) have experienced modest corrections or consolidations. Our sense is that much of this action is due to profit taking, given that some of the hardest hit market areas are those that performed the best in 2017. Nevertheless, investors have reasons to be cautious. Valuations are less attractive than they were several years ago and we have enjoyed a long period of low volatility and positive economic surprises, which could mean markets are overdue for a more significant setback.

That said, however, we just don’t see the necessary ingredients to cause an end to the current economic expansion or equity bull market. We would be much more concerned about a combination of rising bond yields and falling equity prices. Likewise, we would be worried if significant inflation pressures forced central banks to raise interest rates more aggressively than the current path. Such environments are typical of late-cycle bull markets and tend to lead to major equity setbacks, significant economic contractions and/or falling corporate profits.

Looking ahead, we do expect bond yields to rise and inflation to creep higher, but believe both trends should be slow, well contained and not significant enough to derail the equity bull market. Monetary policymakers are still focused on supporting economic growth rather than combatting inflation, which should allow them to move slowly and in a well-telegraphed manner.

More importantly, we expect global economic growth to continue to improve and believe corporate earnings should continue to strengthen. These factors ultimately matter most for stock prices. It wouldn’t be surprising to see volatility pick up in the months ahead, or for equity markets to experience periodic moderate pullbacks. But the fundamental backdrop suggests that this bull market remains intact.