by John Slayton / News
Since the end of the financial crisis in June 2009, the current economic expansion has lived for nearly eight years. Counting from the last major market low in February 2009, the current bull market is now more than eight years old. The Fed has hiked its benchmark interest rate three times in the past few years, while a strengthening dollar over the same period further tightened financial conditions. Arguably, this economy is starting to show its age and anxieties are becoming more difficult to ignore. A review of the anxieties held by investors (you) and investment professionals (us) follows.
Equity Valuations – “The stock market is just too high” is something heard from clients more and more these days. True, after a near 20% rally in large cap domestic equities in a short period of time, it may seem that stocks are expensive, but considering the recovery in corporate profitability as shown in the chart on page 3 (“Earnings Recovery in S&P 500”) perhaps these stocks were just too cheap last year and are now back to where they should have been all along. We think a bottoming of earnings growth rates is illustrated in the right side of the chart. The trend of rising corporate earnings can be seen as well.
Often investors cite the price-to-earnings ratio (P/E) in relation to historical average as a measure of relative value. However, this comparison must be done carefully to consider the impact of changes in inflation rates. Since the early 1970s inflation has declined. During periods of lower inflation, P/E ratios can arguably be higher without being considered too expensive. A simple approximation of an inflation adjusted P/E ratio would be the sum of P/E and an inflation measure, like the Consumer Price Index (CPI). The chart on page 3 (“Inflation Adjusted P/E”) graphs P/E, CPI and the sum of P/E plus CPI. Observing that unadjusted P/E ranges between 10-25 while inflation adjusted P/E has a higher bottom range of 15, one might conclude that current valuation levels may not be as expensive as first thought.
Rising Interest Rates – A worry of fixed income investors is that rising interest rates can serve as a drag on the performance of their bond portfolios. Though our efforts to provide diversification through broad exposure to maturity ranges, industries and geographies are expected to reduce risk, investors who focus on quarter-to-quarter or year-to-year results have a right to be concerned. However, since the Federal Reserve’s first rate hike in December 2015, yields and prices for benchmark 10-year Treasury bonds are essentially unchanged. In November 2015, the U.S. 10-year had yields between 2.2% to 2.3%. As recent as March and April 2017, they yielded between 2.2% to 2.4%. Considering how Gross Domestic Product (GDP) growth rates continue to average less than the 2.5% aim of the Fed, it seems unlikely to us that the pace of rate hikes will dramatically accelerate. Therefore, longer rates should not make a sudden lurch higher, but rather match the Fed’s slow pace. Expectations of a gradual rise in rates showing up as paper losses until maturity while collecting coupon income along the way ought to be satisfactory for bond investors.
The Trump Administration – In discussions of the economy and markets, we refrain from partisan political commentary. However, when objectively viewing the results of what the Trump administration has accomplished in terms of legislation thus far, a fair observation could be that it has been less than what the campaign promised. The reality of governing could serve as a check on then-candidate Trump’s bold promises being enacted.
INVESTMENT PROFESSIONAL WORRIES
Earnings Recovery Stalls – A deeper analysis of the recovery in corporate earnings can give us concerns. At a broad level, there are two issues. First, the low base of previous years has made it easier for managers to achieve profit targets, especially after guiding these lower. Second, there is a casual perception that the earnings recovery may be concentrated in energy and financial sector stocks. Energy companies have benefited from oil rallying from the low $20s to $50 over this time. Banks have actually earned income on their excess reserves while prior to the hikes they did not. Our hope is that the rebound in earnings will not remain limited to only these two sectors, but will expand to the broad market.
Chair Yellen Raises Rates Too Quickly– With more inflationary pressures than a few years ago our worry is not that the Fed has begun to hike interest rates. Rather, our concern is that the Fed hikes too quickly and forces an unexpected deceleration of economic growth. A recession that starts prematurely invites deflationary pressures similar to those last seen in 2008-2009. Also, with little progress being made in per capita income since 2007, a recession beginning before average Americans experienced any wage gains could turn off another generation of investors from investing in stocks.
The Trump Administration – If President Trump is unable to deliver on any of his headline campaign promises, or even only delivers but a pale shadow of them, he could be
a one-term president. It is worth noting here that America’s economic progress during recent one-term presidents (Carter, Bush 41) pales in comparison to those two-term presidents from both parties.
CONCLUSIONS AND INVESTMENT IMPLICATIONS
Our sympathies are with those who feel anxiety over the stock and bond markets. Rather than lament the dearth of opportunities, or wax nostalgically for the higher returns of bygone eras, truly successful long-term investors will focus on using the stock and bond markets to earn the highest rate of return in relation to their risk tolerance. Part of the reason nominal bond yields and equity valuations may seem unappealing today is that investors forget the punishing inflation of bygone eras. In an era where global central bankers have demonstrated they can thwart inflation, the sustained purchasing power of today’s dollars is an often overlooked component of portfolio return. Investors whose assets are properly allocated among stocks, bonds and lower correlated alternatives should have nearly the same opportunity for rewards as they always have.
- First quarter U.S. GDP came in at 0.7% below expectations of 1%. The reading is significantly below the 2.1% growth from the preceding quarter. The main detractor was weaker consumer spending, while business investment was healthy.
- Real personal consumption grew by only 0.3% in the first quarter, down from an increase of 3.5% in the fourth quarter of 2016. This is the smallest increase in consumption since the fourth quarter of 2009. The lack of consumption was fueled by reduced spending on motor vehicles and utilities.
- Core CPI, which removes food and energy costs, fell 0.1% from the prior month, the first decline since January 2010. The YoY core CPI measure is at 2% after the dip in March.
- U.S. nonfarm payrolls rose in the month of April, adding 211,000 new jobs, and coming in above consensus estimates. March payrolls were revised downward to 79,000, somewhat dampening the sentiment of positive data from April.
- Driven by strength in the labor market, the unemployment rate fell 10 basis points to 4.4%, the lowest reading since May 2001. Despite the strong gains in employment, the labor participation rate dropped to 62.9% from the previous month’s reading of 63%.
- Average hourly earnings were somewhat soft, coming in below estimates at a 2.5% YoY pace for the month of April. Month-over-month gains in earnings were in line with the consensus at 0.3%.
- The LEI index, published by the Conference Board, is comprised of 10 economic components and is considered a helpful gauge for estimating economic activity for the subsequent three to six months. The LEI index rose again in March by 0.4%, climbing to a value of 126.7.
- Gains in the LEI index were broad based, led by interest rate spreads and new orders in the manufacturing segment. Six of the components added to the top line figure, while two
subtracted from it.
- According to Ataman Ozyildirim, Director of Business Cycles and Growth Research at the Conference Board, “the March increase and upward trend in the U.S. LEI point to continued economic growth in 2017, with perhaps an acceleration later in the year if consumer spending and investment pick up.”
- Foreign developed equities rallied 3.1% in the final week of April following the first round of France’s presidential election. Investors were relieved after far-right candidate Marine Le Pen’s loss to centrist candidate Emmanuel Macron. Le Pen had made. Le Pen has made investors nervous because she supports leaving the EU. The MSCI EAFE index gained 2.2% in April and is up 10.2% this year.
- Domestic equities faltered in the first half of the month amid weaker economic data that was not consistent with the post-election jump in optimism. Encouraging earnings reports lifted U.S. equities in the second half of the month. The rally brought the technology-heavy Nasdaq and small-cap Russell 2000 indexes to record highs. The Nasdaq closed above the 6,000 level for the first time.
- Earnings momentum continued in the first quarter after S&P 500 earnings grew 8.6%% YoY in Q4 2016. Through the end of April, 66% of S&P 500 companies have reported Q1 2017 earnings. S&P 500 earnings are on pace for between 14% and 17% growth YoY. If this growth rate is maintained, it will be the strongest growth since Q3 2011.
- Half of the S&P 500 companies to release Q1 results have reported revenue that was better than analysts’ estimates. This revenue “beat” rate is very strong compared to the historical average of 34%.
- The industrial sector has been the biggest surprise this quarter with earnings growth on pace for 2.1% growth versus analysts’ estimates for a 5.1% decline.
- Technology and consumer discretionary were the top performing sectors for a second straight month in April and are the best performing sectors year to date.
- A reversal in the financial sector’s post-election rally has led to the sector being among the worst performing sectors for the past two months. The lack of policy progress from the new administration has reduced investors’ confidence in Trump’s ability to deliver policy changes, including bank regulation.
- Energy and telecom were the worst performing sectors in April as reported Q1 earnings and revenue were weaker than analysts’ estimates. Analysts had very high hopes for the
energy sector with revenue estimated to grow 48% YoY due to the recovery in oil prices, but reported growth is on pace to only be 29%.
- In April, the trend toward a flatter yield curve revived itself. While a climbing 2-year Treasury yield combined with a falling 10-year yield to cause February’s flattening, a decreasing 10-year yield accounted for nearly all of the leveling of the curve in April.
- This flattening occurred as inflation numbers and inflation expectations fell during the month. As much of the inflation data are not seasonally adjusted, underestimating the potential for inflation at this point in the year would be unwise.
- With unemployment below most, if not all, published estimates of the natural rate, inflation pressures could begin to mount over the rest of the year.
- High yield and Emerging Market bonds continue to maintain their strength over the rest of the market, with EMs closing the gap on high yield for the highest performing fixed income asset classes over the last 12 months. Every asset class had positive returns in April.
- Since the election in November sparked sell-offs in emerging market and high yield bonds, risk appetites have driven yields to below historical average levels, as investors seek income and are willing to pay more to clip higher coupons.
- In the more traditional sectors, taxable muni performance has outpaced investment grade corporate bonds.
- All asset class spreads remain at tighter-than-average levels to U.S. Treasuries, with agency bonds appearing to be the closest to the historical average. Investment grade corporate bond spreads remain tightest relative to the historical average.
- Tight spreads, particularly in riskier asset classes, tend to signal turning points in the credit cycle. While spreads did widen slightly this month, defaults remain below their historical norms, meaning this cycle may still have legs.
- The value of high yield corporate bonds has improved over the last six months, having reverted to within a half of a percent of their historical mean.
- Broad-based commodities prices seemed to roll over in early March driven by swift declines in both crude oil and industrial metals prices. U.S. crude oil and seaborne iron ore prices have fallen by more than 10% and 30%, respectively, since late February.
- Global real estate and infrastructure indexes were the top performing areas of clients’ alternative investment strategy allocations in April. During April, the decline in the benchmark U.S. 10-year government bond yield, from 2.39% to 2.28%, most likely supported returns for these higher yielding asset classes.
- The year-over-year jump in natural gas prices is largely due to last spring’s suppressed price levels and a warmer-than-expected summer of 2016. Expected supply increases from the U.S. Appalachia region may keep a lid on prices in 2017.
- Global production growth in grains (wheat, corn, soybeans and rice) continues to outpace global consumption. This has led to year-over-year price declines in most agricultural commodities. Wheat output growth in Argentina, Russia and the European Union might lead to a fifth consecutive year of a global grain supply surplus.
- Crude oil prices corrected approximately 10% in April, but key members of the November 2016 production cut agreement, including OPEC heavyweight Saudi Arabia, continue to signal an extension of the deal at their May 25 meeting.
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