We think this is attributable to the synchronized global expansion and foreign stimulus programs taking hold. International equities may be assuming a leadership role as U.S. stocks, which have led other equity markets since March of 2009, hang at record levels. Meanwhile, bond market activity in the U.S. is indicating to us that rates could stay relatively low for an extended period.
Global Economic Upturn and Markets
Since 2016, we’ve witnessed an upturn in the global business cycle. As experienced investors know, economic recoveries can produce relatively attractive opportunities. While some market participants mark the U.S. election as the beginning of the current market run, international markets have been showing progress since July of last year, coinciding with improvements in the economic conditions of both Europe and China. Euro area growth has improved slowly but steadily for the last four quarters, doubling its growth rate of output during that period. The extreme condition of negative interest rates in Europe (and Japan) has eased recently, reflecting improving economic conditions. China, which a year ago was an area of concern, reported a small but welcome (year-over-year) uptick of .1% for the first quarter. Furthermore, we think most global economies are earlier in the business cycle than the U.S. Accordingly, they potentially have longer horizons for economic expansion compared with the U.S.
Earnings and Equity Valuations
In late 2016, the U.S. emerged from an “earnings recession” that started in the third quarter of 2015. As year-over-year earnings declined, stock prices continued to advance, resulting in an increasing valuation issue. Currently, the S&P 500 is trading at 17.7 times forward (expected) earnings for the next year. The long-term average is approximately 14.0 times (source: Factset Earnings Insight – June 16, 2017). It is true that U.S. stocks have traded at much higher relative valuations at various times in the past. Nonetheless, we think that the upside for U.S. stocks is limited from here until earnings catch up with current valuations. We also expect an increase in volatility from the subdued levels of the recent past.
As we know, international equity prices have floundered over the last several years. The result is that we see relatively attractive valuations overseas. Global profits have recovered as much as U.S. profits (in some cases more), but with lower valuations than U.S. equities, implying that overseas opportunities are relatively attractive. While this leads us at Atlas to increase our international exposure, we’re cognizant of the risks from unpredictable geopolitical events, and we are taking a prudent approach to building our positions there.
Interest Rates and the Fed
We think that given current levels of economic growth and inflation, as well as forward expectations for the same, the 10-year U.S. Treasury yield appears slightly over-valued at 2.19% on June 19. This level is near the low end of its 2.0% to 2.6% range since the presidential election. In addition, credit spreads (the additional interest available to investors that are willing to assume some level of credit risk) are narrow.
For fixed income investors, it is important to understand that predicting future interest rate changes is one of the most difficult riddles in the investment arena, so trading rates is perilous at best. That said, we think that intermediate-term and long-term rates are unlikely to rebound to significantly higher levels in the foreseeable future. Our position is based on the knowledge that interest rate changes are largely correlated to changes in the rates of economic growth and inflation. Economic growth is driven by employment levels and improvements in productivity. Given current employment and demographic trends, along with dismal productivity gains and no signs of meaningful increases in inflation, we think interest rates could stay relatively low for an extended period.
In fact, since the December 15, 2016 rate hike by the Fed, longer-term rates have actually decreased. As short-term rates that are more sensitive to Fed actions have increased, and longer-term rates have decreased, we’re observing a “flattening” of the yield curve. If this trend continues (and perhaps causes the yield curve to invert), we would view that as a signal to take a more defensive posture.
As for further Fed rate hikes, we do think we’ll see another rate increase, perhaps at the September meeting. In addition, we think the Fed will begin to reduce the size of their balance sheet (i.e. reduce their lending activities). These moves are done in the context of an economy they believe can absorb the reduction in stimulus, which should be seen as a vote of confidence in the economy. Whether markets ultimately view it that way remains to be seen.
- Global economies are in a synchronized recovery. With international stimulus measures being applied, and relatively more attractive equity valuations outside the U.S., international stocks could assume a long-term leadership position. We are increasing our exposure to international stocks.
- U.S. equities have achieved record levels, but we expect more subdued and more volatile performance in the near term.
- We think the potential for an inverted yield curve in the United States and a collapse of China’s credit impulse present impending risks.
Of course, if you have any questions or concerns, please feel free to contact your Atlas Wealth Management Advisor. They will be happy to discuss your specific situation with you.
Article Written by:
John C. Ogle
Chief Investment Officer
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