July 2015 Mid-month

Key Points and Market Recap

• The drama in Greece may persist for years, but we believe widespread contagion remains unlikely.
• The Chinese market volatility and economic decline are growing as issues that warrant investor concern.
• Despite the risks, we think the outlook for U.S. economic growth, corporate earnings and equities remains positive.

U.S. equity volatility spiked last week, driven by escalating concerns over Greece’s debt problems and a sharp volatility in Chinese equities. The Chinese stock market experienced a dramatic sell-off in recent weeks before staging a comeback toward the end of last week. Early last week, the possibility of additional Greek defaults and a potential messy exit from the eurozone intensified. By the end of the week, however, Greek officials and policymakers seemed to be approaching an agreement. In China, the focus was on the government’s increasing market intervention designed to stem the sell-off, and what the possible economic spillover effects of such actions might be. Few notable developments in the United States affected U.S. markets, although we saw some indications that low expectations for second-quarter earnings could offer a favorable setup for equities. Despite the volatility, U.S. equity prices changed very little last week, with the S&P 500 Index flat.

Weekly Top Themes

1. U.S. economic data is improving, and we expect the Federal Reserve to begin rate hikes this fall. In our view, the first four months of the year exhibited disappointing economic results, but conditions have been improving. The June employment report was mixed, but we see strength across housing, construction, consumer spending and other leading indicators. From mid-May through the end of June, 78% of cyclical indicators have been positive, according to ISI research.

2. Corporate earnings should accelerate in the second half of this year. Earnings experienced a downtrend from late last year through the first quarter of 2015, thanks in large part to falling oil prices and a soaring dollar. We believe analysts' revisions may have turned too negative about corporate fundamentals, and we expect some positive earnings surprises in the coming quarters.

3. European growth may be stumbling. In Germany, business confidence fell for a second straight month in June due to concerns over Greece’s debt problems, the recession in Russia and the severe economic slowdown in China. We expect European economic growth to slow somewhat in the coming quarters, but also believe the European Central Bank has the flexibility and willingness to engage in additional actions to prevent widespread financial contagion.

The U.S. Economy Should Weather Escalating Global Risks
Uncertainty over the negotiations between Greece and its creditors is quite high, and markets react daily to the latest news and rumors. The odds seem to favor Greece agreeing to most fiscal reform measures, which could provide the country with some more breathing room. At this point, we think it is more likely than not that Greece will remain part of the eurozone, but the road ahead will be rocky and Greek debt issues may well remain for years to come.

The recent equity market crash in China and the government’s response is, in our opinion, potentially more serious. It is difficult to foresee how the government’s unprecedented market intervention may affect the broader global economy and financial markets, and the risks of contagion are unclear.

The Chinese market volatility and economic slowdown has helped cause another downturn in oil and commodity prices, and given the uncertainty about what may happen in China, we would not be surprised to see further near-term declines. So far, the issues in China have been relatively contained. However, given the size of the Chinese economy, the possibility of a severe slowdown in China has to be taken seriously. For the moment, we do not see enough warning signs that such a situation is imminent.

For the U.S., the trifecta of Greek debt problems, the Chinese slowdown, and volatile commodities present economic risks, but most believe the balance of evidence suggests that U.S. economic growth should continue to improve. The U.S. economy appears to be accelerating. While the ride will not be smooth, it is expected ongoing growth in consumer spending will act as an increasingly strong tailwind for the U.S. This increased spending should allow corporate earnings to recover and improve, which in turn should help U.S. equities climb unevenly higher. While U.S. equities are no longer table-poundingly cheap, we believe they offer better value than other financial assets and should outperform cash, bonds, inflation, and commodities. Even though equities are likely to advance further, the pace of gains is likely to be slower than what investors experienced during the first six years of this bull market.

Stock Valuations Do Not Appear To Be Excessively High.
Many believe that stock valuations show the potential for continued positive returns, even for U.S. investors. This view is based, in part, on the absence of the kind of investor enthusiasm that has heralded the end of a bull market in past decades. The Fed is unlikely to stymie economic growth, even as it raises rates to more normal levels. If the economy expands, company profits in the U.S. should do likewise.


Although expectations of profits were declining until fairly recently, we think it was a temporary dip. Earnings per share (EPS) for the S&P 500 Index went up from 2011 through the third quarter of 2014, but a combination of oil and the dollar pushed them lower. These numbers are stabilizing now, and we believe there are several factors that will help them rise. Capital expenditure plans that are beginning to gain steam, consumer confidence that remains healthy, and purchasing manager indexes that continue to be in expansionary territory in most of the developed world. While U.S. equities no longer look cheap—and, by some measures, they look expensive—we believe the excessive investor zeal that could signal the start of a bear market is absent.