Mid-Year Outlook: Bright Spots New Risks

THE SECOND-LONGEST BULL MARKET in United States stock market history often seemed under pressure during the first half of 2018. Yet despite dropping by more than 10% at one point, and going through quite a few ups and downs, the market managed to edge higher this spring.

What's next? In this interview, Christopher M. Hyzy, Chief Investment Officer for Bank of America Global Wealth & Investment Management, shares his perspectives on where we are at mid-year, weighing the risks that could stall the bull market against the positives that could extend its run.

Q: What's behind the sharp pick-up in volatility this year—and what does it tell us about the health of the market?

A: We're in the late stages of one of the longest bull markets in U.S. history, and this year's volatility comes as investors wonder when and how it could end. Every potential threat is magnified. Bond yields are rising, luring some investors away from stocks, and higher commodity costs and rising wages could cut into corporate profits.

There's also a potential change in party leadership in Congress and the threat of trade wars, as well as political uncertainty and economic weakness in Europe and geopolitical risk in the Middle East and Asia. But there are just as many reasons to remain optimistic about stocks’ prospects, particularly in the U.S.

Q: Recently, turbulence in Europe has sparked volatility. Do developments there present problems for U.S. equities?

A: There are two issues in Europe. One is political instability in Spain and Italy. The other is slowing economic growth in the European Union. If growth in Europe continues to weaken, that could negatively impact U.S. equities, especially if we see anemic growth in Europe and tighter financial conditions in the U.S.

Q: Let's get to those reasons to be optimistic: what factors could help keep the bull market going?

A: The most important is the U.S. economy, which is the healthiest it has been in almost 10 years. Business confidence is high, which increases capital expenditures. That should stoke further growth and productivity, and help keep a lid on inflation. Consumer spending, which accounts for about 70% of U.S. gross domestic product (GDP), is likely to rise because last year's tax cut bill is putting more money in consumers' pockets. We also expect above trend global economic growth. All of this bodes well for corporate earnings, which we think will take stock prices to the next level.

Q: And what level is that?

A: At the end of last year, we forecast the S&P 500 could reach 3000 at the end of 2018. We’ve extended that timeline a little. Now we expect it could reach that number within the next six to 12 months. Stock valuations have fallen recently, and we think the combination of cheaper stock prices, stronger corporate earnings and a healthy economy creates a good environment for investors.

Q: What do you see as the biggest risk to the bull market?

A: Our biggest worry is a jump in inflation that would make the Federal Reserve more aggressive in raising interest rates. Yet while commodity prices have risen this year—and some labor shortages could translate into higher wages—automation, outsourcing and other factors may help moderate wage growth. So while we might get a bout of short-term inflation, we don't expect it to last.

Q: How many more rate hikes do you expect from the Fed?

A: The Fed has said it wants the federal funds rate (a key short-term interest rate) to eventually reach 3%— a "neutral" level that neither stimulates economic growth nor chokes it off. Right now that rate is 2% and we expect it to hit 2.5% in 2019. That's a very modest increase and nothing that should trigger an economic recession or bear market in stocks.

Q: What advice would you suggest investors consider for the rest of the year?

A: We tell them diversification is their friend. But it’s important to diversify not just with different kinds of assets—stocks, bonds and cash—but also within each asset class. With stocks, that means holding high-quality large-cap stocks spread across multiple sectors, particularly those such as financial services and technology that tend to do well when economic growth is accelerating. Looking beyond U.S. borders, stocks in emerging markets still have very good upside potential because they remain cheaper than equities in developed markets.

Q: Does being diversified still mean holding bonds?

A: Absolutely. Today’s rising interest rates could hurt investors who don’t hold bonds to maturity, but an allocation to fixed income is needed to diversify risk. Here, too, you need good diversification, with Treasuries, municipal bonds and high-quality corporate bonds. But as interest rates head higher, it makes sense to emphasize bonds with shorter maturities, which are less sensitive to rate increases.

Q: So, summing up, despite the risks, does this second-longest bull market in U.S. history have more room to grow? Could it go for the record?

A: Absent a spike in inflation or an all-out trade war with China—neither of which we foresee—stocks should continue to rise into 2019. There are more worries now than there were at the beginning of the year, but we think healthy economic growth should translate into solid corporate earnings over the next several quarters and power the market to new heights.