Get In Shape for the End of the Year

By Brian Dolan, Head Market Strategist August’s Bloodletting Looks to Have Ended

Markets were shaken out of their summer doldrums in recent weeks, and most of the year’s gains in major stock indexes were erased in just a few weeks. Emerging markets took it on the chin especially hard in August, with the MSCI Emerging Market Index dropping over 15% in August alone, matching the EM drop from the April highs.

As I argued in my recent post “Remain Calm” (link), the market sell-off appears to have been mainly position-driven (longs getting dumped and shorts getting squeezed), aggravated by automated trading systems (“the ‘bots”), and not the result of any meaningful fundamental change. Indeed, by the end of last week, major developed markets had recovered and closed on the plus side for the week (see the weekly chart of the MSCI World Index below). Even the MSCI Emerging Market Index posted a positive close for the week (not shown).

MSCI World Index of Major Developed Stock Markets-Weekly View

get fit for year end image

Source: Bloomberg; DriveWealth

While stocks are still down for the summer, the recent sell-off serves as a reminder that markets don’t always go up, but also that short-term market price movements can provide long-term investors with opportunities to take actions in line with their investing strategy.

With that view in mind, let’s take a look ahead to see what the rest of the year may have in store for markets and investors.

The Fed and Lift-Off

Perhaps no other question has pre-occupied markets more in the last year than the timing of the Fed’s first interest rate increase in nine years, referred to as ‘Lift-Off.’ I’m staying with my long-held view that the Fed will refrain from hiking this year, but markets have been constantly shifting in their expectations. According to Fed Fund futures data, current pricing suggests a roughly 40% chance of a ¼% rate increase at the September 17 FOMC meeting, up from around only 20% at the peak of last week’s volatility, but down from the near 60% likelihood before global markets dived.

Either way, I don’t foresee any meaningful harm to major global markets from a minor Fed rate increase off the zero lower bound. The Fed has taken its sweet time in preparing for lift-off, and markets and the broader US economic recovery have proved unfazed. More important will be the future course of Fed policy moves. I expect the Fed to signal in very clear terms that it is not embarking on a series of tightening moves, leaving markets free to continue to expect an extremely low-interest rate environment for the foreseeable future. So whether the Fed hikes or not, I would continue to look for opportunities to add to long risk holdings, stocks in particular.

The US recovery continues to grind along amid a backdrop of below-target inflation. Meanwhile, other major central banks, most notably the European Central Bank (ECB) and the Peoples Bank of China (PBoC) will continue to pursue easy-money policies, keeping a lid, if not outright pressure, on global interest rates. Global stock markets should continue to benefit from low rates and investors really have no alternative to achieve meaningful returns. My preference is to continue to focus on the major developed markets (US, Europe and Japan). However, in light of the sharp declines in emerging market stock indexes this year, I would also increase allocations to those markets with a longer-term investment view.

China is the Question Mark

Recent global volatility was also sparked by market declines in China and a renewed focus on the outlook for Chinese growth. While other major markets recovered most of their recent losses, Chinese markets remain in correction-mode. This condition seems most likely to continue as the majority of Chinese retail investors remain stuck in leveraged losing positions. I expect government efforts to support Chinese markets to minimize further losses, but it’s difficult to see a near-term return to the bubbly levels of a few months ago.

The real concern emanating from China is the degree of slowing that will be seen in the coming months, and the risks there remain biased to the downside. Negative data out of China will continue to impact global markets, but generally only on a short-term basis, providing increased opportunities for more active, short-term investors. Commodities are likely to remain the biggest casualty of Chinese weakness, so I would continue to avoid commodities as an asset class. The current oil-fueled rebound in commodities is likely to stall out in the coming weeks. Prices in the CRB broad commodity index remain well below significant resistance levels and global demand does not appear set to reignite any time soon.

In terms of the price action of major stock markets, last week’s low may have been a significant medium-term bottom, suggesting timing may be short for investors who did not yet take advantage of last week’s dips. Markets are likely to remain in summer-mode for another week or so, as the US has the traditional end-of-summer Labor Day Holiday on Monday Sept. 8. However, the August US jobs report is due out on Friday Sept. 4, with the ADP private payroll survey preceding it on Wednesday, potentially adding some sparks to a jittery market. Then, once the Fed is out of the way on Sept. 17, we would look for markets to get back to more normal conditions and potentially set the course for the rest of the year.