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Equities are on pace for their best year of this expansion, and despite compounding uncertainties as we hit the halfway mark in 2019, realized volatility is below historical averages. Stellar returns have largely been fueled by the Fed’s significantly dovish pivot, however. A perfect storm of policy uncertainty is brewing, and we expect volatility to reemerge in the second half of the year.

Equity markets are first and foremost challenged by diminishing fundamentals. Corporate profits fell 2.8% in Q1, the largest quarterly drop since 2015, reflecting, in part, decelerating economic growth. Trade tensions have also had a significant effect on U.S. earnings. Companies with a high percentage of revenue generated from foreign countries have seen earnings per share (EPS) drop over the past year, while companies with domestically derived revenue saw earnings rise.

Beyond moderating growth is a long list of policy uncertainty that we expect to stoke volatility. While investors have hope for a U.S.-China trade agreement, we see trade tensions as a genie that will not easily return to the bottle. Recently, it was the unexpected threat of tariffs on Mexico that caused volatility to spike in early May. This was quickly soothed by markets pricing in an additional 55 bps of rate cuts by the end of 2019. But relying on Fed rate cuts carries its own risk: The Fed may not ease as much as markets expect. Even the most dovish Fed official is well short of some market participants calling for four rate cuts.

There are factors supporting equity markets as well. Record-high stock buybacks continue with no sign of slowing and could very well continue to bolster equity valuations in the short to medium term. With uncertainties lining up on both sides, we see higher volatility as the most likely scenario during the second half of 2019.




Read the analysis for each indicator:

The corrosive effects of policy uncertainty

Trade tensions
Monetary policy
Interest rates

Sentiment indicators are more important than ever

Business sentiment
Consumer confidence

Don’t ignore key recession indicators

Yield curve inversion
Initial claims

Equity volatility looms, high yield stands to benefit

Equities
Fixed income

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