The recent correction has led equities to trade much closer to their long-term averages in the U.S., below average in developed markets, and well below average in most emerging markets. The global economy is growing modestly, primarily driven by below average interest rates rather than strong global consumption. The U.S. is further along in its recovery relative to the other developed countries and is likely the first to begin increasing rates. As a result, the U.S. dollar has strengthened given the prospect of higher interest rates. While a strong U.S. dollar has depressed corporate earnings expectations, it makes imports cheaper and should provide a boost to consumer spending, which represents about 70% of the U.S. economy. The U.S. economy is still the most stable developed market and continues to grow at a measured pace. Resilient consumers, low unemployment, modest inflation, and low interest rates offer support for current valuation levels. The S&P 500 Index earnings outlook calls for flat to negative earnings growth in the coming quarters. However, with the exception of the Energy and Materials sectors, earnings are projected to increase.
International developed equity markets have yet to fully recover from the recession. The MSCI EAFE Index is still trading more than 20% below its prior peak. A weak euro, cheap oil prices, low interest rates, and a historic expansionary monetary policy from the ECB has the European markets pointing in the right direction after years spent in the long shadow of the U.S. Both Europe and Japan face hurdles, and their governments appear committed to supporting their economies at almost any cost. The Eurozone has repositioned itself for growth, and investors are beginning to move funds into the region on expectations of an economic recovery.
Rate cuts in India and China support growth, and more cuts could follow if growth falters or inflation drops. Chinese officials acted quickly when export growth slowed and the property market lost steam. China cut rates four times in 2015 and took other measures to spur economic growth and support the stock market. The story in emerging markets continues to center around low commodity prices, weakening currencies, and slowing earnings growth. China and India are positioned for relatively attractive growth as they stand to benefit from a growing consumer base and lower commodity prices.
The Fed believes the slowdown in the first half of the year was transitory and that growth will rebound in the coming quarters. Low global interest rates will likely keep them from moving too quickly due to U.S. dollar strength and the risk that a wider spread will push the U.S. dollar even higher. The Fed held rates steady at the September meeting and identified slower global growth and low inflation as the primary reasons. The probability of a rate hike in 2015 is fading, and the market expects the first move to occur in the first quarter of 2016. U.S. bonds are not providing their traditional level of downside protection during periods of increased volatility as their correlation to stocks has risen well above normal levels. Bond returns should be muted and could dip into negative territory in 2015 if global economic growth proves unexpectedly strong. When the Fed does raise rates, they will likely do so slowly and carefully. A rate hike should serve as an acknowledgement that the economy has strengthened enough to withstand it.
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