Global markets may have come off their lows in late May and early June, but the risk-off trade has yet to run its course.
I’ve called for another summertime slump since the end of the first quarter, citing three factors: the reversal of seasonal strength in US economic data caused by warm winter weather, rising concerns about the EU sovereign-debt crisis and growing concerns about the 2013 fiscal cliff of tax hikes and spending cuts in the US.
My outlook hasn’t changed one iota. Three years into the recovery, US economic growth remains anemic, job creation continues to falter and consumers have reined in spending in favor of saving and paying down debt.
However, investors shouldn’t worry that the US will lapse into recession. The domestic economy will continue to expand at a lackluster pace; until analysts’ reduce their estimates, key data points will fall short of expectations. Investor sentiment has shifted over the past six months, but economic conditions haven’t budged.
The market has also refocused on the EU sovereign-debt crisis after taking a three-month hiatus in the wake of the European Central Bank’s long-term refinancing operations. The EU has slipped into recession and will gradually muddle through its debt debacle, but investors shouldn’t expect headlines from the region to provide a major tailwind.
Meanwhile, the US presidential election cycle brings a great deal of uncertainty about the future of the nation’s fiscal policy and the expiration of the George W. Bush-era tax cuts. I expect the election to yield a divided government that will reach an 11th hour compromise to forestall most of the fiscal pain. Nevertheless, the four months of uncertainty prior to the election should lead to a volatile stock market.
With investors continuing to de-risk their portfolios and pare exposure to cyclical holdings, more downside could be in store for commodities and energy-related stocks.
Nevertheless, I expect the current panic to subside over the next month or two. As in 2010 and 2011, stocks and commodities should bottom and rally into year-end. Potential catalysts for this upsurge include efforts to reduce the pressure on Italy and Spain’s borrowing costs, accelerating economic growth in China and the realization that the US economy will skirt recession once again.
Investors should focus on high-yield, dividend-paying stocks such as master limited partnerships (MLPs). High-quality stocks that offer exposure to key long-term growth trends are also worth a nibble. In both cases, investors should ease into these positions to take advantage of any further downside.