Market Commentary - 9.26.2014

2014 May Break the Pattern

For years the pattern has been the same. At the beginning of the year forecasters acknowledge that growth has been weak but they expect a pickup later in the year. As the year wears on, however, the monthly numbers disappoint or come in mixed and forecasts are marked down. This year seemingly had a similar story — severe winter weather led to a sharp turndown in economic activity in the United States in the first quarter, followed by a bounce-back in the second quarter. The consensus now among economists is that real GDP growth will settle in to a trend-like 3% rate in the second half and into 2015. Paradoxically, meanwhile, equity markets have risen worldwide as corporations have found ways to raise earnings despite the uneven and generally sluggish growth in their economies. Is this pattern coming to an end, or can we look forward to a repeat of the now familiar pattern?

In the United States, the case for stronger growth appears to be on fairly solid ground. No single sector is booming, but most are showing signs of sustainable expansion. Equipment spending by corporations is this year rising, housing construction is on track to rise at a double-digit pace in the second half of this year, consumer spending is solid, and with belt-tightening largely over in state and local governments, government spending, which has declined for four years in a row, will no longer be a drag on growth. The picture abroad is not as rosy, but there are reasons to expect an improvement in coming quarters. The European Central Bank (ECB) has initiated a number of measures to stimulate the Eurozone area while the Japanese government insists that it is pushing forward with further monetary stimulus measures and to follow through on promises of fundamental reforms in the regulatory hamstrung Japanese economy.

As it has been for the past several quarters, our investment stance is based on a base case scenario that allows for cautious optimism. The U.S. economy seems to be getting onto a path of modest, non-inflationary growth. Economic performance in Europe and Japan has disappointed, but massive monetary stimulus and weakening currencies point to a pickup in activity within a few quarters. Interest rates appear to be poised to rise gradually in the United States, but not abroad. Stock markets around the world have managed to do well in worse circumstances than these over the past few years, and there might seem no reason to expect otherwise in the near future.

While the outlook for the global economy is generally favorable, it would be foolhardy not to acknowledge the existence of downside risks. These include a surprise jump in inflation driven by potentially higher labor costs, the global economy reverses its recent improvement, and China’s economy stumbles. These risks are not so great, but a prudent strategy would be to brace your portfolio against unanticipated market volatility as the market tries to gauge the likelihood of these downside risks. From an investing standpoint, we continue favor developed markets that stand to benefit from the expected improvement in the economic outlook, a slight overweight in growth relative to value stocks, less interest rate sensitivity in fixed income, and extreme diversification including alternative strategies, commodities, and REITs.

This information is compiled by Cetera Investment Management.

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