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Buckle up for the second half of the year, stock market investors.
With trade wars brewing and the midterm election looming, some analysts say the stock market could see plenty of bumps in the second half before ending the year with a bounce.
Stocks are exiting the weakest first half year performance for the in three years. The index is up just 1.6 percent year to date, and there are some indicators that are flashing warnings. For instance, the Dow Transports briefly fell into correction territory Thursday, and the Dow Industrials were trading below their 200-day average, a closely-watched indicator for price momentum.
Institutional investors are less bullish going into the second half, but 70 percent believe the market has seen the lows of the year in February, according to a fresh survey of 500 investors by Strategas Research. The investors expect the U.S. to be the best performing equity market through year-end, but their average S&P 500 target has sunk slightly to 2,842.
“Typically on average, what’s happened is the S&P suffers a correction of about 18 percent in mid-term election years, and so what is interesting about that is typically after the election, when there’s more clarity of who is in charge, the market tends to rally,” said Michael Arone, chief investment strategist at State Street Global Advisors. “In fact, every mid-term election year since the 1940s, the market has had a positive return.”
Arone said if history is a guide, there could be volatility, even a correction and then a move higher at the end of the year. “We could be shaping up for that type of finish in the second half,” he said.
But analysts also say that pattern of summer bumpiness may occur simply based on the number of headwinds facing the market. The market tends not to like the uncertainty of trade threats, tariffs and the potential impact on corporate profits, they said. There is also the prospect of more Fed rate hikes, and if short-term interest rates begin to rise so much more quickly than long term rates that they end up higher than the longer term yields – or inverted – that too would be a negative, since it is a recession warning.
Lori Calvasina, chief equity strategist at RBC, said she currently prefers small caps to large given the fact they are insulated from some of the volatility of trade issues, due to their strong domestic exposure. Recently, she switched from neutral to overweight because trade looks to be an issue that will be pushed during campaign season.
“We think the summer is going to be rough for stocks. It feels like we’re setting up for a lousy summer and maybe into the early fall then you get the late year rebound after the election,” said Calvasina. Trade is just a big issue that’ snot going away…It feels to me like it’s a campaign issue…Wall Street Republicans hate it, but Main Street Republicans don’t, so it makes sense.”
The election could also bring its own uncertainty, as some analysts say it would be negative for the pro-business agenda if Democrats were to gain control of either House. Sixty percent of those surveyed by Strategas expect Republicans to hold onto the House, but they are concerned about trade issues.
“Trade is certainly one of the things that is weighing on investors’ minds. The Trump administration has a tough choice. We are now entering the mid-term election campaign season. The choice the Trump administration has to make is whether to placate the base or placate the market, and it seems they’re not sure which direction to go in and it’s leading to volatility…The market is unclear how this is going to shake out,” Arone said.
Art Cashin, director of floor operations at UBS, said trade issues are such a concern that he is not ready to call a play book for the second half. He said trade is the overhanging concern, and there has been chatter about China devaluing its currency. That talk has been dismissed by analysts, but it still hangs over the market as a potential weapon China could use to make its exports more attractive if trade skirmishes escalate. Cashin also said some of the internal weakness in the stock market is a concern, including the decline in transports.
“Some of the technical are starting to look a little shaky and you’re going to have to get past that,” said Cashin.
The market does have many positives going for it. The GOP tax plan pumping up profits, and the fact that corporations are buying back stock at a record clip should keep a bid in the market. But with rising rates, analysts also say the rising dollar is a potential negative for earnings, and Calvasina said sector analysts are already seeing concerns from companies about the greenback.
Calvasina agrees that the U.S. has become the best market to invest in , but there are still worries. She sees the S&P ending the year at 2,890, from its current level at 2,716, and Arone also sees it a few percent higher, but some analysts see the S&P well above 3,000.
“There’s a rotten undercurrent to this market that I can’t quite put my finger on. It’s not fundamentals. It’s not the economy. It’s not valuation. There’s something unsettled in the backdrop,” Calvasina said.
There are also geopolitical risks that can't yet be quantified. For instance, oil prices have been rising amid concerns the U.S. sanctions on Iran could cause some shortfalls in the second half of the year.
While some investors are worried the Fed will be too aggressive, John Bredemus, head of capital markets at Allianz Investment Management, said he is not. He also does not expect interest rates to move in a way this year that would signal a recession in coming months. The 2-year yield, at 2.51 percent, was just 32 basis points below the 10-year Treasury yield at 2.83 percent, the closest or flattest they’ve been since 2007.
“We’re just not seeing much upward pressure there. We continue to think the curve is going to flatten,” he said. “The reason I think it’s different this time is it’s the first time the Fed has had a lever at the long end of the curve. They have their balance sheet. They have talked a lot about not wanting to invert the curve like typically happens at the end of a Fed tightening cycle. They have the ammunition to make sure this doesn’t happen. I don’t think it’s going to invert this time.”
Bredemus said he’s not concerned about eh Fed moving too quickly or upending the market, and he expects it to keep inflation contained. The 10-year yield should range between 2.75 per cent and 3.25 per cent this year, he said. The Fed is forecast two more rate hikes for this year.
But he too is concerned about trade and the uncertainty is making it difficult for businesses to make decisions about the future.
“I do believe that we need to get this trade situation resolved in a way that doesn’t lead to more and more escalation of protectionism…People get concerned that this administration in particular will break away from norms and do things differently than what has happened in the past,” Bredemus said. “They’re walking a tight rope. They believe they need to get some concessions out of countries on trade, but they also don’t want to cause a problem in the economy. This is a different tact than the U.S. has taken in the past. Let’s see if it works. "