The interest rate increases are not “negative or problematic yet,” said Erik Knutzen, chief investment officer of multi-asset class investing at Neuberger Berman. But “if economic growth and inflation continue to come in very soft and potentially roll over, it’s possible that the Fed will engage in a policy mistake.”
A widely followed, continually updated forecast of national economic output from the Federal Reserve Bank of Atlanta declined to 2.6 percent annual growth for the second quarter from an earlier 4.3 percent outlook around the beginning of May. That is after a meager 1.4 percent annualized growth announced for the first quarter.
In another sign that the economy is flagging, demand for credit has moderated. After increasing at more than 7 percent a year in 2014 and 2015, the rate slipped to 6.5 percent last year and just 2.6 percent in April, according to the Fed.
The yield curve has flattened, meaning long-term bond yields have fallen as short-term rates have risen. An inverted yield curve, in which short rates are higher than long rates, often heralds a recession.
Meta indicators like the Citi U.S. Economic Surprise Index, which compares economic readings with forecasts, went from its highest level in more than three years, recorded in mid-March, to a six-year low around the end of June.
Investors are facing “a little bit of a mixed message” from the hawkish Fed and the feeble economic indicators, said Scott Klimo, co-manager of the Sextant International Fund. Stocks have remained strong, in his view, because investors are choosing to believe messages coming from Washington, and not just from the Fed.
“I think there’s a lot of hope in the marketplace, in particular hope for reforms from the federal government” to overhaul the tax code and spend big money upgrading the nation’s infrastructure, Mr. Klimo said. He cautioned that investors had become conspicuously complacent, but then added that “absent some external shock, it does seem as though things can cruise along for a little bit” in the stock market.
He envisions biotechnology and other health care stocks cruising along better than most, as effective ways to overhaul the provision of medical care continue to elude policy makers. The right blockbuster drugs can enrich the companies that make them while saving lives at lower cost than other treatments. Cancer drugs developed by Merck and Bristol-Myers Squibb are notably promising, he said.
Health care was among the strongest groups of stock funds in the second quarter, with the average portfolio up 6.5 percent, according to Morningstar. Industrials and natural resources were notably weak. As well as the health funds did, they managed on average to trail the 7 percent return of Health Care Select Sector SPDR, a popular exchange-traded fund that tracks the sector.
The average domestic stock fund over all was up 2.7 percent in the period. Bond funds rose 1.4 percent.
International stock funds beat their domestic counterparts handily. The average one gained 5.6 percent, led by portfolios that invest in Europe, China and India.
Given their concerns about valuations and economic growth, it’s no surprise that investment advisers are looking abroad for opportunities. Mr. Klimo is a fan of Chinese internet stocks, like Tencent and Alibaba. Like many investors, he is unenthusiastic about oil, he said.
Tim Guinness, chief investment officer of Guinness Atkinson Funds, also likes stocks in China and the region around it.
“The cheapest part of the world is the Far East” excluding Japan, he said. “China is making a good transition from investment-led growth to consumption-led growth.”
Mr. Guinness foresees China following the same path of development that Japan did from 1970 to 1990, an excellent time to own Japanese stocks.
“We’re increasing our weightings significantly to the Far East and reducing them to the U.S.,” he said.
He is wary of American stocks because he finds them expensive. He has no concern about the Fed raising rates during a period of iffy economic growth.
“The time is well past for stopping quantitative easing and increasing interest rates,” Mr. Guinness said. Quantitative easing is the program of asset purchases that the Fed used to shore up the economy after the financial crisis. The Fed is expected soon to start disposing of the assets it bought, another source of worry for many investors.
Mr. Guinness cited a number of largely overlooked difficulties resulting from extremely low rates. Low rates limit the earnings of banks, forcing them to be overly cautious in their lending. Low bond returns limit returns for savers and force companies to add more cash to their pension plans, reducing capital investment.
“You’ll be amazed that interest rates going up will be good for markets, not bad,” he said.
Edward Yardeni, president of Yardeni Research, maintains a bullish outlook on the stock market and a glass-half-full view of the economy. The yield curve may be flattening, but at least it’s not inverted. As for the Citi surprise index, he finds it to be a volatile indicator that often bounces back quickly from plunges like the recent one as economists adjust their expectations after the data disappoints them.
“I think the economy is still performing pretty much the way it has been since 2010,” Mr. Yardeni said. The modest growth in the first quarter, the most recent one for which a figure has been released, “seems slow, but you’ve got slower growth in the labor force.”
The number of people available to work is not expanding as much as it used to, limiting economic growth. He noted that the meager growth rate had been enough to keep unemployment below 5 percent. That should allow the Fed to nudge short-term interest rates to 2 percent next year, he predicted, from about 1 percent after the June increase, and give the central bank ammunition if the economy begins to stall.
One benefit of the modest pace of growth is that even with so few out of work, Mr. Yardeni said, inflation remains low. Consumer prices rose just 1.6 percent in the 12 months through June, according to the Bureau of Labor Statistics, and the unemployment rate was only 4.4 percent. For May, the Atlanta Fed recorded national wage inflation of 3.4 percent.
“As long as inflation remains subdued, and as long as we don’t have a recession, bonds and stocks should continue to work,” Mr. Yardeni said.
James Paulsen, chief investment strategist at the Leuthold Group, wonders how long low inflation will continue to support the markets. He warned in a note to investors that inflation is a risk, despite the tepid economic growth.
Wage growth has been tame, but with few suitable people left to hire for companies that need to expand to meet consumer demand, it could flare up, he said. Productivity growth, often a way to keep a lid on prices, has been low after years of modest capital investment, he added.
“Investors should prepare for both wage and consumer price inflation to rise between 3 and 4 percent in the next couple years,” Mr. Paulsen said. “This does not imply a recession is looming or a bear market for stocks is imminent,” but “it implies a major investor mind-set change.”
Even with inflation quiescent, the rich valuations and a so-so, or worse, economy make even some bulls less than enthusiastic about stocks.
“If someone came into a lot of money and asked what to do with it, they have my condolences,” Mr. Yardeni said. “Everything has been picked over.” He added, though, that he doesn’t “see any particular reasons to get out of stocks or bonds at this point.”
He encouraged investors to stick with stocks that have healthy dividend yields, and he prefers technology as a rare source of growth these days and energy stocks as “a good contrary bet.” He would also give emerging markets a chance. But not all of them.
“India stands out, China does not,” he said, disagreeing with Mr. Guinness.
Mr. Knutzen at Neuberger Berman recommended Treasury Inflation-Protected Securities, which are Treasury notes and bonds that rise in value if inflation goes up, and debt issued in emerging economies. He has been reducing exposure to stocks of large American companies and investing more in smaller companies and overseas markets where valuations are lower.
“We have become more cautious in our views,” Mr. Knutzen said. The economic backdrop provides “an O.K. environment for stocks, but there’s not much margin for error.”