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Janney 2015 Outlook: Mid-Year Update

Economy and Equity Markets Outlook By Mark Luschini

Little has changed since the beginning of the year to alter our view from the expectation of steady, if unspectacular, economic progress-now six years old-is continuing. Several anomalous factors disrupted first quarter performance, but the second quarter has improved rapidly to resume the trend we anticipated. Meanwhile, the rest of the world is somewhat mixed, but in the aggregate, nets out to a sturdy pace of global economic growth.

Various Economic Scenarios and Probable Outcomes - Remainder of 2015

In this section, we describe three possible scenarios that may unfold in the economy and markets as 2015 progresses. The probability attributed to each case is based on mid-year conditions and our resulting expectations. While there are no certainties, we offer this forecast as helpful guidance on what to expect for the remainder of the year.

Scenario Analysis (S&P price is 2,094 as of this writing)

Optimistic Case: 25% Probability

  • Economy and Markets: The economy continues to provide unambiguous evidence that the expansion is intact, helped by modestly improving conditions abroad. While the Fed begins to lift interest rates, it is well-telegraphed and expected to be gradual. With bond markets medicated by the Fed's explicit forward guidance, yields drift higher but glacially, exerting little pressure on earnings expectations. The P/E multiple expands to 18/19 on $132 of earnings, and the S&P 500 melts up to 2,400. Approaching this level engenders talk of a "bubble" in equity prices. It may warrant scrutiny for profit taking opportunities because history is replete with bubbles ending badly.
  • Investment Strategy: Stocks prosper as investors project further profit gains and lack of competition for risk-based capital from other asset classes. Favor large cap dividend "Aristocrats" in the areas of technology, financials, and health care. Consumer-facing companies should be owned as well. Bonds struggle in price, but generally cover any loss in principal by the yield. Avoid gold.

Base Case: 65% Probability

  • Economy and Markets: The "goldilocks" economy continues to print positive growth. Job growth and spending fuel a reinforcing expansion cycle, and global activity stabilizes. The Fed debates a mid-year liftoff in the fed funds rate but defers-deciding to err on the side of allowing any overheating it might generate to occur. The conflict for market participants about when the Fed might pull the punch bowl away creates anxious moments and increased market volatility. Corrective bouts are common but do not disrupt the long-lasting bull market. Stocks beat bonds as the S&P rallies through occasional pullbacks to 2,175.
  • Investment Strategy: Stocks should be at or above weight against portfolio targets. Bond prices waver, but global disinflationary forces and the arbitrage by country agnostic yield-seekers tame bond market volatility. Hedges may be helpful to temper swings in equity prices. Low or non-correlated instruments may be augmentative within a portfolio construct, including alternative investments, gold, and the U.S. dollar.

Pessimistic Case - Probability: 10%

  • Economy and Markets: The economy slips well below forecast as employment gains slow, while foreign economies fail to reaccelerate. Businesses are unwilling to invest ahead of visible demand, and the consumer saves the oil price "tax cut" rather than spend it. Withering profit expectations cause a de-rating in equity prices. Earnings grow only by low-mid single digits year/over-year, and markets resolve the disappointment by showing little gains. The S&P trades in a range around 2,050. Bond prices rally, and returns rival or exceed that which come from stocks. Income is the driver of results, so dividend stocks and corporate bonds deliver attractive yields and total returns.
  • Investment Strategy: Blue chip stocks with predictable growth are rewarded. Defensive sectors such as Utilities and Staples should perform. Stocks should be reduced to target weight or slightly below, as return risk is elevated. Higher-quality bonds hold relative appeal, and duration targets should be extended. Cash, alpha generating hedge strategies, and real assets may be best-suited to augment an unrewarding environment for traditional asset classes.

A weighted blend of these scenarios establishes an achievable price target for the S&P 500 of 2,219.

Risks Worth Monitoring

  • Valuation-agnostic cash and underperforming investors chase the stock market significantly higher. S&P 500 2,500 plus.
  • Lending activity in Europe slows and fails to ignite and demand remains muted, causing the economy to weaken and equities there to suffer.
  • The Fed tightens policy more quickly than anticipated, and jars complacent markets. 2013's "taper tantrum" is replayed in earnest.
  • Oil prices fall well below the cost of production, and the U.S. energy renaissance stalls costing jobs and business investment.
  • China's debt problems are unmasked, and worries escalate about its sustainable growth rate and global economic contribution.
  • Russia remains an aggressor in Eastern Europe, and more imposing tit-for-tat sanctions weigh on market confidence.
  • Japan loses its fight to reignite growth as reinvigorating economic policies are thwarted-causing the yen to rally hard.
  • Central bank policies overstep investor confidence, leading to a redo of the Fragile Five currency losses expanding to infect others.
  • A terrorist movement in the Middle East interferes with the oil supply chain, driving prices markedly higher-hurting the global economy.
  • An attack on U.S. soil, physical, cyber, or otherwise, or an ebola-like pandemic scare, darkens consumer sentiment and curbs spending.