July 21, 2021
Scott Wren, Senior Global Market Strategist
Volatility equals opportunity
- The financial markets are sensitive to the potential for a growth slowdown, potentially triggered by a spread of the COVID-19 Delta variant.
- We believe the prospects of widespread lockdowns similar to last year and early this year are small and recommend taking advantage of downside volatility.
Questions about future growth are starting to bother the stock market. But many would argue that the bond market has been hinting for some time, through lower yields on the 10-year Treasury note and some other maturities, that economic growth may not be as strong or last as long as some market participants believe. The pullback in the commodities markets, as reflected by the prices for raw materials such as oil, copper, and lumber, could also be interpreted as signs that future growth/demand prospects have diminished. Note that our projections call for a robust 7.0% gross domestic product (GDP) growth this year and 5.3% GDP growth in 2022, and we continue to believe we are in the early stages of a new economic cycle that has multiple years to run.
While some market indicators have been reflecting some investor caution over the past month or two, this week’s opening trading session also brought to the forefront concerns that the COVID-19 Delta variant may impact the global economic reopenings that markets have been counting on. Equities will not look kindly on implications that a meaningful rise in virus cases could bring about an eventual return to lockdowns. Our opinion is that potential precautions will be milder and lockdown measures localized, if enacted, than those disrupting economic activity in 2020 and earlier this year. Elevated vaccination rates, particularly in developed countries, are limiting the number of severe cases and hospitalizations, likely discouraging the sort of stringent lockdowns disrupting earlier economic activity.
We have been looking for a pickup in volatility, likely triggered by uncertainties over the future trend of inflation in coming quarters and what the Federal Reserve (Fed) might do about it, if anything. Another potential trigger ties together COVID-19 fears and the effects of lockdowns on growth. Higher inflation readings and a Fed that might taper bond purchases sooner rather than later have so far not spooked investors.
Given all of the above, the question is, should downside volatility be viewed as an opportunity to put sidelined funds to work or not? In our case, given our positive outlook on future vaccine progress, Fed monetary policy and government fiscal stimulus and their resulting effects on employment, consumer spending, and ultimately corporate earnings this year and next, the answer is yes.
We continue to lean into sectors sensitive to the recovery, such as Energy, Industrials, Materials and Financials. We are also favorable on the growth-oriented Communication Services sector and are recommending full allocations to Information Technology and Consumer Discretionary.
Averaging into the equity market over time is a recommended strategy, but should a pullback of a more meaningful magnitude develop, we advise committing additional funds to the market.
Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.
Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. Communication Services companies are vulnerable to their products and services becoming outdated because of technological advancement and the innovation of competitors. Companies in the communication services sector may also be affected by rapid technology changes; pricing competition, large equipment upgrades, substantial capital requirements and government regulation and approval of products and services. In addition, companies within the industry may invest heavily in research and development which is not guaranteed to lead to successful implementation of the proposed product. Risks associated with the Consumer Discretionary sector include, among others, apparel price deflation due to low-cost entries, high inventory levels and pressure from e-commerce players; reduction in traditional advertising dollars, increasing household debt levels that could limit consumer appetite for discretionary purchases, declining consumer acceptance of new product introductions, and geopolitical uncertainty that could affect consumer sentiment. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Investing in the Financial services companies will subject an investment to adverse economic or regulatory occurrences affecting the sector. There is increased risk investing in the Industrials sector. The industries within the sector can be significantly affected by general market and economic conditions, competition, technological innovation, legislation and government regulations, among other things, all of which can significantly affect a portfolio’s performance. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market.
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