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Investors Should Be on Alert for a Summer Pullback in the U.S. Market

Summer is a time when some investors may put their portfolios on the back burner and head out on the sailing boat for some fun in the sun. Conditions for U.S. stocks appear to be relatively smooth, illustrated by still-low volatility and major indexes near record highs. We believe stocks will move generally higher, supported by solid earnings, low inflation, and a modestly growing U.S. economy, and we certainly don't begrudge investors taking a little rest and relaxation. But below the surface there are developments to heed, including ongoing geopolitical and monetary policy uncertainties. Keeping a diversified portfolio is important, as is periodic rebalancing, as a geopolitical blowup, a monetary policy "mistake," or a major political shakeup could occur with limited warning signs.


As noted, volatility—albeit still low historically—has ticked higher; while sector rotation has been the name of the game lately. Technology and energy stocks have moved lower over the past month, while financials and health care have rallied—again illustrating why paying attention to the makeup of your portfolio, and being mindful of diversification, can be important.


This rotation, as well as occasional modest pullbacks in the overall indices, appears to be keeping investor sentiment from getting overly optimistic. This two-steps-forward-one-step-back movement is what we believe will help to extend the long-running bull market and, for now, help prevent a "melt-up" scenario. As good as they feel while they're in motion, they don’t tend to end well.


Economic growth more like a pontoon boat than a speed boat


Earnings are about to come back into focus as second quarter reporting season is kicking off. Expectations are elevated and we believe the recent move higher in stocks has been largely fueled by a solid earnings picture. While in waiting for earnings announcement, economic data has been mostly positive and indicative of an ongoing expansion—albeit a mature one. Investors may be hoping for more of a speed boat look to economic growth, but we believe that pontoon speed, while not exciting, is likely to be more beneficial to keeping the bull market going. Modest growth helps to keep inflation in check, monetary policy fairly loose. There has been a weakening in some "soft" data as surveys and business/consumer confidence have been playing a little catch-down to more subdued "hard" data, which is typically how wide soft/hard data divergences are corrected. We would expect that narrowing to continue if the Trump administration's pro-growth policy proposals continued to get pushed out in time.


The hard data continues to provide a mixed picture with the labor market continuing to look strong. The Labor Department reported that 222,000 jobs were added in June, surprising on the upside, while the unemployment rate ticked slightly higher to 4.4%, although wage growth remained modest as average hourly earnings posted a 2.5% year-over-year gain. But the recent durable goods orders report from the U.S. Census Bureau was soft, falling 1.1%, while nondefense capital goods orders ex-aircraft—a proxy for more sustainable capital spending—fell 0.2%. Additionally, the Census Bureau’s retail sales reading was surprisingly soft given the still-healthy labor market, with sales falling 0.3% in May and being flat month-over-month ex-autos and gas.


That said, the important Index of Leading Economic Indicators, put out by the Conference Board, continues to indicate further economic expansion. This set of indicators is giving no sign of growing recession risk.



Can the Fed successfully navigate these waters?


This mixed economic picture, combined with the recent retreat in some inflation measures, has raised the level of uncertainty regarding future Federal Reserve actions. The Fed is intent on continuing the normalization process, with balance sheet reduction gaining a share of the spotlight from rate hikes. Interestingly, some foreign central banks may have aided the Fed in its campaign with more hawkish commentary recently from the heads of both the European Central Bank (ECB) and the Bank of England (BoE) helping to push U.S. Treasury yields modestly higher, which can also be seen in the "benchmark" rate in Europe—the German 10-year Bund.


Combine the move in yields with a modest rebound in some commodities such as iron ore and copper may have folks wondering in the reflation story is again gaining traction. We believe it's too early to buy into that, especially with inflation readings remaining low, but it is something to keep an eye on, and could potentially add some more choppiness to the waters as we sail through the summer months.


So what?


The environment for U.S. and global stocks continues to be in decent shape, but some risks are elevated and the possibility of a pullback exists. A notable potential driver of bouts of volatility could be U.S. and global central bank policy as they sail toward monetary policy normalization.


Important Disclosure 
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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