1. Central Banks Find It Hard to Part
The diverging central bank policies we discussed at the beginning of the year continue to play out. As the Fed sets a course to raise interest rates, roughly 20 of the 75 biggest economies have cut rates in the first half and, notably, the Bank of Japan and the European Central Bank (ECB) remain in easing mode. But an interesting paradox has developed: The dollar strength resulting from divergence has become a headwind for many U.S. corporations dependent on exports. This, in turn, has contributed to slower growth in the U.S. economy, which has made the Fed cautious about raising rates.
Key Takeaway: Expect divergence to continue for the next several months. The dollar should remain strong, albeit with some reversals, which means downward pressure on commodities prices, inflation and the earnings of U.S. exporters.
2. Fed Will Lift Off, World Will Not End
The Fed has made it clear that it will finally raise its short-term interest rate target over the next few months. While this is a significant event, we do not believe it is the game changer many may assume. To begin, rates will increase from zero to simply low. In addition, structural factors such as an aging population, which increases demand for income and bonds, are likely to keep rates low over the long term. Still, there will be some impact—in fact, we’ve already seen rates inch up, along with volatility.
Key Takeaway: Short-term bonds will be most affected by higher rates, while longer-term bond yields should inch up at a gentler pace. High-dividend stocks that have served as “bond market proxies” are also likely to suffer, but overall, stocks’ reaction to liftoff should be relatively tempered.
3. U.S. Economy Slow, But Moving Forward
One of the striking developments of 2015 has been the weakness of the U.S. economy compared to the relatively high expectations many had going into the year. The main culprits: the stronger dollar, severe winter weather and a West Coast port strike. And while the employment picture has brightened, consumer spending remains sluggish. We still believe the U.S. economy is headed in the right direction and expect a resumption in growth in the second half.
Key Takeaway: Slow-but-steady growth in the U.S. economy should support modest advances in stocks.
4. Inflation Showing Shades of Low
Despite numerous calls for a spike, U.S. inflation remains comfortably low due to a number of factors, some short term (a strong dollar, sluggish demand for products) and some long term (aging populations, technological innovation). In Europe, where inflation had been too low, the ECB’s easing measures have pushed the readings back into positive territory. In Japan, however, inflation is too low, veering perilously close to deflation.
Key Takeaway: Comfortably low U.S. inflation is good news for American businesses and consumers, and lending some support to stocks. But the bigger impact may be felt in European stocks, which stand to benefit from further ECB easing.
5. With Fed in Play, Expect More Volatility
After a period of relative calm in April and early May, stock market volatility has started to inch up again, coincident with increasing expectations for a Fed rate hike. And while current volatility readings are below the long-term trend, we acknowledge that even moving back toward “normal” can be painful. The bright side of this bumpy ride is that conditions are still broadly supportive of stocks. That means any corrections that volatility brings aren’t likely to be too severe— and may present buying opportunities.
Key Takeaway: Volatility will be higher than the unusually low levels of recent years, but market dips may present buying opportunities.
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Written by Russ Koestertich of BlackRock