For the second quarter in a row, both stock and bond prices have risen simultaneously. Equity markets are signaling improving economic growth while fixed income markets apparently fear the opposite. The Federal Reserve held a steady course when it raised rates for a second time this year. On a political front, the situation remains fixed as Congress continues to work on a healthcare bill and tax reform. Corporate revenue and earnings growth were positive last quarter and stock multiples continue to expand while GDP growth expectations fell. Broadly speaking, things feel a bit “rich” to us these days and caution seems warranted.
Recent data has shown signs of economic weakness: declining industrial production, another period of deflation, slowing housing permits, declining retail sales, anemic employment gains (the recent July report was a notable exception), plateauing automobile sales all paint a discouraging picture. Year over year comparisons are more benign and reinforce the slow growth environment that has characterized the last 8 years. It’s always a mixed bag and there are positive indicators as well – the stock market is pricing in better times ahead. In our opinion, the easiest way to achieve more robust GDP growth is fuel from fiscal policy since monetary policy is in a tightening posture (i.e. the Fed is raising interest rates).
We are hopeful that wage growth and business capital expenditures will also sustain growth. Toward this goal we note that the most recent ISM Manufacturing Index (in June) hit the highest level since August 2014 with a reading of 57.8 which beat consensus expectations handily. The dividing line between economic expansion and contraction is 50.0 and June marked the 10th consecutive month the ISM Index has been above 50.0. The key takeaway from the report is that it featured a faster pace of new orders, which bodes well for future production and serves as a good sign of increased manufacturing demand. According to the ISM, the past relationship between the Purchasing Manager’s Index (PMI ) and the overall economy indicates that the average PMI for January through June (56.4 percent) corresponds to a 4.1% increase in real gross domestic product (GDP) on an annualized basis. In addition, if the PMI for June (57.8 percent) is annualized, it corresponds to a 4.6% increase in real GDP annually. If that comes to pass, we will have the more robust GDP number the market needs to move higher.
The most recent jobs number (in July) came in much stronger than expected and surprised economists. Wages came in a bit lighter than we had hoped, but with more people entering the work force and energy prices falling, consumer spending should benefit. This is good news for our economy as 70% of our GDP comes from consumer spending.
For the second quarter of 2017, the S&P 500 posted a positive 3.1% return. Year to date, the S&P 500 is now up 9.3%. According to the Wall Street Journal, the S&P 500 has finished in positive territory for the full year 31 of the 33 times (94%) it was up at least 8.0% after the first half of the year. In addition, global stock markets are now rising in sync (see chart).
Nine of the eleven economic sectors in the S&P 500 posted positive results. The Healthcare sector was the best performing sector during Q2 (up 7.1%). Healthcare is the second best performing sector year to date (up 16.1%), trailing only the Technology sector (up 17.2%). Delays in Healthcare reform and investor focus shifting away from drug pricing have taken some pressure off Healthcare companies.
The two negative sectors during the quarter were Energy (down 6.4%) and Telecommunications (down 7.1%). These two sectors were also the only negative sectors during Q1 and the only sectors in negative territory year to date. Oil prices have fallen around 15% this year as concerns over both excess oil inventories and increasing U.S. production continue to linger. Pricing competition has hampered the Telecom sector and consensus expectations for earnings in 2017 are for a decline of 1.4%.
As an astute observer may have guessed (based on the above sector commentary), growth stocks have outperformed value stocks by a wide margin over the last six months. So far this year, the S&P 500 Value is up 4.9%, while the S&P 500 Growth is up 13.3%. In this relatively low economic growth and low interest rate environment, investors have flocked to growth sectors while eschewing value sectors. According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is now 17.4x, which is above the 5-year average (of 15.3x) and the 10-year average (of 14.0x). The P/E ratio is one way to gauge the attractiveness of stocks, and we continue to be mindful of valuations, especially after the recent strong performance in the equity markets.
The taxable bond market, as measured by the Barclay’s Aggregate Index ETF, made gains for most of the quarter but abruptly corrected in the closing days. The index was up 1.58% for the period, and was off about 0.58% in the last 4 trading days. The 10-year treasury hit a low yield of 2.13% on June 14th and closed the quarter at 2.31%. This volatility is both Fed and Congressionally induced. The Fed raised the overnight rate by 25 basis points on June 14th and signaled more rate hikes were inevitable with timing being the only variable. The primary change was the Fed’s tone toward balance sheet reduction which should begin in the near term assuming economic conditions persist. While the raising of the Fed Funds rate from virtually zero to a still low 1.0 to 1.25% is intended to create a more “normal” interest rate environment, a reduction in the Fed’s balance sheet will have a more direct impact on impeding economic growth. The Fed has more than $4 trillion of mortgages and Treasuries on its balance sheet, and selling these holdings periodically will reduce the supply of money which in turn lowers the amount of excess capital that banks could otherwise lend. This will most likely take pressure off of inflationary forces. With this dynamic in play, the yield curve has flattened. Keep in mind that the Fed directly controls short-term interest rates while the market’s inflation expectations control longer term rates. The chart below shows how the Federal Reserve views the shape of the yield curve and the predicted GDP growth. As the yield curve flattens (i.e. the yellow line falls) as has been the case, GDP growth expectations fall. We expect these forces to wax and wane until we get a clearer picture of how aggressive the Fed balance sheet reduction will be and how effective Congress will be in fueling growth and therefore inflation expectations.
The ten-year Treasury began the quarter yielding 2.39%, and closed June 30 at 2.31% even as the Fed Funds rate increased. We are being cautious in this volatile period and are focusing on the five-year sector of the yield curve. Shorter-term bonds will be more impacted by Fed rate-raising actions and we are not comfortable going out longer than ten years with the potential Fed induced supply of bonds on the horizon.
The tax-free municipal market was a little stronger, up 1.65% as represented by the iShares National Muni Bond ETF. Municipals have been in favor all year as the market continues to recover from the post-election sell-off and no progress on tax reform has materialized. Credit quality concerns are increasing nationwide as can be seen in the recent downgrade and budget fight relating to the state of Illinois. The ratings agencies warned Illinois that if the state enters the third year without a budget then junk ratings are on the horizon, which would dramatically increase the state’s borrowing costs. After initially missing the deadline a veto override got the budget passed, albeit with dramatic tax increases. While spreads improved after this “accomplishment”, Illinois 10-year bonds are yielding north of 4%. The national benchmark is seen below, and is hovering around 2%. It appears investors are holding each individual state/issuer responsible and the domino effect has thus far been muted, much like the Detroit bankruptcy.
The chart below shows the rally in the municipal market since the start of 2017, where 10-year yields have fallen from the 2.5% range to 2% today. Secondary supply in high quality bonds is constrained, and new issuers are oversubscribed in many cases. We are taking a little longer to spend down cash after this impressive rally. Our focus has been, and will continue to be, on the AA and higher rated sector and sound municipalities with strong financial characteristics.
We started this letter by noting that equities are anticipating improving economic and profit growth while the bond market is fearing the opposite. We do not know which is correct, but our aim is for the middle path. While we believe some stocks are priced too optimistically right now, we continue to find value in where we feel comfortable investing. To reiterate, we do think caution is warranted but we do not see a “doom and gloom” situation on the horizon. For bonds, we are less sanguine as interest rates appear to be range bound barring some surprise.