A pause in the bullish market on the way.

A new secular bull market started at the lows in 2009. Although it may soon be interrupted by a period of instability as the market digests an environment of rising interest rates and a lack of EPS growth, investors need to remember that investing is a long-term game. Investors need to return to fundamentals and start investing again based on their own convictions, rather than relying on support from central bank quantitative easing.

Outlook for Equity markets 

The new secular uptrend that commenced with the lows in Q1 2009 is likely to enter a broad trading range for the remainder of 2013 and possibly into 2014 as well. The US and European equity markets have already discounted a continued improvement on the macro front, but the market now needs to see more positive surprises to drive the next major upleg. The two most imminent risks the market faces are 1) a general rising interest rate environment, and 2) the possibility of earnings disappointments in the upcoming company reporting seasons. After more than four years of recovery, therefore, there is likely to be a pause in the action before the current secular uptrend resumes in earnest in 2015. This scenario is not at all bearish, but rather I expect equity markets to trade in a wide range for now. That said, it is important to emphasize that equities are poised to continue their long-term winning streak and are set to beat bonds on a multi-year year outlook. Taking a long-term view on the increasing value of equities, the S&P 500, for example, is likely to continue trading well above its 45 degree trajectory for a very long time to come, just as it has performed since the 1920s.

Given the inevitability that the markets will be weaned off QE in the foreseeable future – a process known as tapering – there will surely be some volatility over the next 12 to 18 months. We have already witnessed a sharp jump in long term interest rates recently, albeit from an abnormally low starting point. The Central Banks will try their best to talk down rates, and it could be that they stay in a higher range for awhile before the next significant move > 3%. It is not necessarily the higher level of rates that is disturbing, but the rate of change which has caught the market off guard of late.

Certain sectors look better prepared for future interest rate hikes than others: The consumer discretionary sector still offers a wealth of opportunity across all regions and sub-sectors and should survive the first wave of impending interest rate rises intact. Healthcare stocks are a unanimous “buy” now and financial stocks are attractive, especially those in the US where loan growth and the credit markets are expanding more rapidly than elsewhere.

Outlook for Bond markets

Over the next six to 12 months, we can expect to see the yield on 10-year US Treasuries surpass 3% and the yield on Bunds to break through the 2% barrier. It has been quite awhile since we have witnessed divergent paths on the interest rate front, but that is exactly what we are likely to see going forward. The risk remains that the US will unintentionally export higher interest rates abroad just as they did lower rates during the Financial Crisis. At the moment this is only a risk, but the fact remains that bond markets often trend higher and lower together irrespective of their individual macro backdrops.

In this environment, HY bonds still appear attractive after the recent rise in yields as corporate default rates have stayed low and are not expected to deteriorate much as the recovery slowly expands. Only in an environment of rising long rates and deteriorating fundamentals would HY face a severe headwind.

Further, select corporate bonds still offer value especially as the wall of money that had entered bond flows has fallen significantly the past few months, creating opportunities at the individual level that did not exist during the tidal wave of inflows the past few years.

Conclusion

With a strong cross wind emanating from China and EMG in general, the markets are confused and lack strong conviction about where the macro indicators are heading. But even within EMG space, stock picking is still working very well and there are many stocks with very low correlation to the general index that continue to perform very strongly. Although asset classes have performed relatively well since 2009, a closer look at how they have performed in 2013 shows bonds and commodities are in the red – the only exceptions are global equities, global property and US high yield, but these asset classes, too, have been following a downward trend since May. Since growth expectations have not really moderated at all yet, the burden of proof to keep the long-term secular uptrend going is definitely in the bullish camp now. In this context, a lack of EPS growth is a risk, if reality does not match expectations over a prolonged period.

Against this backdrop, investors – above all – need to find their conviction again and think longer term as the near-term environment might prove difficult to navigate. Stay focused and do not confuse any short term weakness with longer term goals, equity markets are very likely continue the new secular bull market over the next 5 – 10 years.

By Jeff Hochman, Director of Technical Analysis and member of Fidelity’s Asset Allocation Group

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