With the recent run-up in the markets in anticipation of future economic growth, a hike in the Fed’s overnight lending rate, and a full slate of presidential policy initiatives that could affect the domestic and global economies, we think that we’re at a turning point in terms of the drivers of asset returns. For years now, concerns have surrounded extremely low Central Bank policy rates and the idea that they may be “propping up” markets. As we enter 2017, it’s clear that investors are shifting their focus to the prospect of a lowered U.S. tax structure, a reduced regulatory framework around businesses, and more governmental stimulus spending as drivers of a renewed growth phase for the economy. Equity investors appear jubilant about the future. Meanwhile, the bond market is not signaling as much confidence. As is often the case, the truth probably lies somewhere in between.
THE ECONOMY AND THE FED
Recent numbers show the economy regaining fundamental strength. Unemployment is down to 4.7%, jobs are being added at a healthy pace, and wage growth is picking up. Year-over-year inflation is running at about 2.7%. Corporate earnings are rebounding after many quarters of negative performance. Small business optimism is high. Recent numbers show a rising real estate sector.
So, clearly the Fed was compelled to raise the Fed Funds overnight rate in their recent meeting. The improving economic numbers supported the move. We now expect that there will be two more rate hikes this year – an increase from what we were expecting at the end of last year. This reflects not only the strengthening of the economy, but the need for the Fed to re-arm itself as well.
FIXED INCOME – The rise in the Fed Funds rate affects the short end of the yield curve. So short-term rates are heading north to be sure. But this doesn’t, in and of itself, portend higher rates across the board. Further out on the maturity spectrum, things like long-term economic growth and inflation, and credit risk play increasingly important roles in the determination of interest rates.
A good gauge of the bond market’s assessment of future growth and inflation is the difference in yield between two year and 10 year U.S. Treasury notes, known as the 2 – 10 spread. When this spread widens, it indicates that the bond market collectively projects that growth and inflation may increase in the future. Remarkably, the 2 – 10 spread has not widened much at all since 2015, staying in the approximate range of 1.2% – 1.4%. This does not correspond with the recent display of exuberance in the equity markets, and warrants continued monitoring.
Another bond market signal is found in the yield difference between “high yield bonds” (B credit rating or below) and a U.S. Treasury bond of the same maturity. This is known as the “credit spread.” Credit spreads reflect the willingness of investors to take on risk in return for additional interest income. In fact, 2016 saw interest rates on high yielding corporate bonds come down significantly. Credit spreads have contracted from about 9.0% to 3.85% as of this writing (Bank of America Merrill Lynch US High Yield B Option-Adjusted Spread). This may surprise some investors who a year ago believed rates could only go higher.
We think that the threat of meaningfully higher rates negatively impacting bond valuations is perhaps one of the most hyperbolic topics in the investing community. While we do expect rates to move moderately higher, we currently have no reason to believe that a spike will occur or that bonds in general represent any extraordinary risks.
EQUITIES – This March 9th was the eighth birthday of the current bull market, which has seen the S&P 500 move up over 209%. In fact, U.S. large-cap stocks have lead the way versus most other major equity indices for the last year. Since the U.S. election on the November 8th, the S&P 500 is up approximately 10% as of this writing. Is the market getting ahead of itself? Is the “Trump Bump” over, and are stocks over-bought? Maybe. But not to any alarming degree.
The Price to Earnings multiple, or P/E Ratio, is a commonly used measure of valuation. Currently, the S&P 500 is selling at a valuation of about 17.7 times projected earnings. This is above both the 5-year and 10-year averages (15.0 and 13.9, respectively). We think that earnings will rebound further to confirm general market levels, and more normal valuation levels will be achieved over the next couple of years. Many cyclical sectors are showing better-than-expected earnings trends, some defensive sectors are also outperforming, and an eventual recovery in the energy sector could serve as a catalyst to further growth. All in all, we continue to recognize that we remain in a bull market until proven otherwise. It rarely makes sense to fight the tape or try to time the market. Accordingly, we continue to maintain healthy equity allocations in our proprietary portfolios, are taking profits selectively, maintaining the proper balance of allocations, and stabilizing assets to be used for anticipated distributions.
As for international stocks, things are shaping up and becoming more interesting to us. With several meaningful elections taking place in Europe this spring, and possible opportunities (despite uncertainties around U.S trade policy) in Asia ex-Japan, we will remain watchful and may consider increasing our allocation to international.
CONCLUSION – We think that remaining committed to a diversified allocation, consistent with the investor’s risk tolerance, will continue to be the most likely path to investment success. At this point in the cycle, we do favor cyclical sectors. To be sure, markets have surprised many observers over the last year, and more specifically, over the last few months, however we do not think that current valuations signal a time to make major portfolio changes. Instead we advocate taking profits and ensuring the proper asset allocation is maintained.
“FAR MORE MONEY HAS BEEN LOST BY INVESTORS PREPARING FOR CORRECTIONS, OR TRYING TO ANTICIPATE CORRECTIONS, THAN HAS BEEN LOST IN CORRECTIONS THEMSELVES.”
LEGENDARY FUND MANAGER PETER LYNCH
ARTICLE WRITTEN BY:
John C. Ogle
Chief Investment Officer
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