Midway through 2017 and most investors, minus those with significant holdings in the energy sector, would be happy if the year ended right now. Despite ongoing concerns about the lackluster strength of the U.S. economy and extended valuations, major U.S. stock indexes are hovering near all-time highs as investors push this bull market well into its 9th year, making it the second longest bull market on record. Not only did the first half have solids gains, but it did so with exceptionally low volatility. The S&P 500 pulled back a negligible 2.8% from its peak in March, marking the second smallest first half drawdown on record.
U.S. stocks weren’t the only profitable market in the first half. In fact, both emerging market and non-U.S. developed equity markets served up even better returns than the U.S. In the SMS January 2017 market commentary, I suggested that after years of underperformance, non-U.S. stocks might be ready to outperform given their attractive valuations and improving fundamentals. That was certainly the case. As of the June 29th close, the S&P 500 registered a 9.1% total return while the ACWX (All Country World Index excluding the U.S.) gained an impressive 14.67% total return. Other noteworthy trends this year are “growth” outpacing “value” and “large caps” outperforming “small caps,” both of which are the reverse of last year.
Growing corporate profits as well as expectations for more government deregulation, corporate and personal tax reform, and new fiscal spending are all forces working to keep U.S. markets on an upward trajectory this year. Underpinning all this bullishness are still ultralow long term government interest rates and the Fed whose accommodative policies are bolstering higher stock valuations.
The big question for the markets heading into the back half of the year is whether or not things are about to change? In the months ahead we will find out just how well the U.S. consumer-based economy is performing with a higher prime rate. The base rate used to set most consumer-oriented loans (i.e. credit cards, auto loans, student loans, and home equity lines) has ticked up from 3.5% in December, 2015 to 4.25% as of June, 2017. Recent retail sales and durable goods data have been disappointing. Furthermore, there is a great deal of uncertainty surrounding the Fed’s desire to start reducing its mammoth $5 trillion dollar balance sheet later this year.
If the bond yield curve is any indication of what lies ahead, there is reason for some caution. Instead of long term interest rates rising along with short term rates (as is typical with a strengthening economy nearing full employment), long term interest rates have been falling as of late. The yield on the 10 year U.S. Treasury bond has fallen from 2.45% at the start of the year to its current 2.28%. While interest rates can be volatile and short term movements less meaningful, the drop in rates be may be foretelling subpar growth coupled with disinflationary pressures. This, of course, would be a troublesome development for the Fed which remains determined to achieve the elusive not-too-hot or not-too-cold 2% target inflation level.
With the U.S. economy in the more mature stages of the business cycle and the Fed transitioning to a less accommodative monetary policy stance, investors should look to reallocate portfolios back to targeted U.S. equity levels as well as maintain diversification in non-U.S. equities. The U.S. bull market may not end anytime soon; however, the time to manage risk is when things are going well, not when they are going poorly.
With regards to fixed income, investors that have moved heavily into high yield bonds should upgrade to higher quality, shorter duration holdings as the incremental yield from junk bond issuers is not compensating for the additional risk at current levels.
A hallmark of this bull market has been its ability to chug along despite uneven, subpar economic activity. In keeping with this theme, the stock market’s solid first half advance coincided with meager first quarter real GDP growth of 1.4%. Moreover, absent a strong rebound, growth is unlikely to average much more than 2% the remainder of the year. Against this slow growth backdrop, inflationary pressures continue to be mild.
From the chart below, you can see that despite the ultra-aggressive policies from the Fed, inflation remains stubbornly below the Fed’s 2% target. With the recent decline in long term rates, and oil and commodity prices falling again, the narrative at the Fed may soon shift from being concerned about percolating inflation to the threat of disinflation as was the case several times over the last decade.
Volatility in the oil market is nothing new. With that being said, it’s been a particularly tumultuous ride the last few years as prices plunged from over a $100 a barrel in 2014 to a low of $30 in early 2016. Then, prices recovered to the high $50’s, only to slide back down into the current low $40’s. Energy is the only sector in the red for the first half of the year, down roughly 13%.
The fundamentals of the global oil market have not been supportive of higher prices with both global supply and demand rising by roughly 1% a year. Despite OPEC production cuts, crude remains in abundant oversupply and the 14 – nation member cartel along with other oil producing powerhouses like Russia continue to struggle with how to respond to a world awash in oil and low-cost U.S. shale producers able to make profits at low price levels. Furthermore, longer term consumer trends towards ride-sharing services, electric and autonomous driving vehicles may also act to suppress oil demand, particularly in more developed nations.
Barring a major supply disruption from an unforeseen event, the dynamics in the energy sector do not seem poised to materially change anytime soon, likely leaving crude to trade in a range ($40-$60). As prices rise, oil producer will increase supply; thereby putting a ceiling on further gains.
While a low price for oil is a boon for consumers, too low, or collapsing, prices can be destructive to the global economy as it stymies further capital investment, suppresses inflationary pressures, and leads to losses for lenders and investors in the sector. The most likely scenario is that oil is close to bottoming around current levels. Not a great scenario for producers, but one that the markets can digest. A more precipitous drop back to the $30’s or lower would likely rattle the global markets, given the higher range of global uncertainties it will unleash.
The Fed has had a lot on its plate the last decade. The Fed has had to embrace conventional as well as unconventional methods to navigate through a horrific financial crisis and anemic recovery. Now, with the economy on seemingly sounder footing, the Fed is trying to unwind some of its more extraordinary policies. So far, it has had some success of moving the Fed Funds rate off of 0% to its current 1% – 1.25% level. The financial markets have handled this move reasonably well and time will tell how the real economy does with higher borrowing costs. It would not be surprising to see the Fed take a breather from further rate hikes with both the price of oil and longer term interest rates declining. The Fed does not want to risk pushing too hard on the economic brakes until renewed disinflationary symptoms dissipate.
The other significant consideration for the Fed is what to do about its enormous balance sheet. The Fed grew its balance sheet from $700 billion to over $4 trillion through its quantitative easing (QE programs) where it bought U.S. Treasury and other government-backed debt securities on the open market in an effort to provide more stimulus to the financial markets.
Just how well the Fed can and will reduce its balance sheet and the ramifications for the markets remains highly uncertain. Any moves will be slow and well telegraphed so as to lessen the potential for major market disruptions. With that being said, this is ground breaking territory and market reactions can be significant any major missteps. The Fed has indicated it would like to initiate balance sheet reduction measures in late 2017 so we will not have to wait too long to see how this plays out.
Housing (Non) Starts?
A bright spot for the U.S. economy for the last several years has been the strength of the residential construction and housing market. After the housing bust and ensuing financial crisis, the residential market has been one of the cornerstones of the economic recovery. From the chart below, you can see that after collapsing to a seasonally adjusted annual 450,000 – 600,000 new homes started per year in 2009-2011, the number has moved steadily back to a much healthier 1.2 million in 2016. The long term average is still closer to 1.5 million homes started a year. However, a recent trend shows housing starts softening the last several months. Factors such as lack of supply of skilled workers and shortages of buildable lots may be responsible. Regardless, it is an area worth watching as it can turn from being a boost to the economy to a drag should the numbers continue to deteriorate.
The extended low interest rate environment has led many to fill the more conservative buckets of their portfolios (aimed at providing capital preservation and downside protection) with a variety of higher income-generating investments (i.e. junk bonds, REITs, MLPs, etc.). In doing so, they have avoided higher quality, lower yielding bonds, including U.S. Treasuries. This so-called “stretch for yield” has generally worked as the volatility in these investments has been minimal and the returns compelling (except for MLPs which have been under pressure along with the energy sector). With market complacency setting in as we reach the later stages of this cycle, investors should evaluate the risk in the “safe” part of their portfolios. Some exposure to these types of investments offers good income and portfolio diversification; however, too much to these types of investments may lead to unanticipated risk and unintended consequences.
Moreover, with the recent Fed hike, the opportunity cost of holding some cash is not as bad as it was when rates were at 0%. With the yields on money market funds getting closer to 1% as compared to low-mid 2% range on core bonds, holding a strategic cash allocation is beginning to make more sense. Those with cash can take advantage of future market dislocations.
Also, continuing to put a heavier weight towards U.S. larger caps (both growth and value) and diversifying into non-U.S. stocks at this point in the cycle makes sense as we may be entering a longer term period of non-U.S. equity outperformance.