rising yield curve
Much of the activity in the stock market since November 8th, both in the US and around the world, has been a speculative response to the election results. The surprise optimism was evident in November, as stock prices measured by the S&P 500 rose 3.7% (0.7% prior to the election and 3.0% after). Year to date, stock prices have risen 9.8% and by most standards, 2016 has been a reasonably good year for stock investors. Historical returns for the S&P 500 average 10% per year, and recently stocks returned 1.3% in 2015 and 13.3% in 2014.
Amidst the frenzy of tweets and conjecture, many investors are having trouble developing an actionable thesis. So, the immediate question is, what facts do we have to work with? First, interest rates have risen on the long end of the curve in anticipation of higher growth and inflation. Unemployment is hovering in the 4.6% range, low enough to spark wage inflation among the prime-age workforce. Consensus is the Federal Reserve will raise rates at its December 14 meeting. The US$ is higher today versus the Euro than any time since ’03. Historically, energy prices and the US $ are inversely correlated. And, since November 8th, technology (de-globalization) and health care (elimination of affordable care) have underperformed, while financials (higher interest rates and de-regulation) consumer discretionary (tax cuts) and industrials (fiscal spending and infrastructure) have been bid up smartly by investors.
The cup half-full view of what’s to come is compelling. Some fiscal spending may give the economy the boost it has long yearned for. Lower tax rates are a pure windfall, and the combination of the two may well lift GDP above its recent 2-2.5% ceiling. The last time GDP was north of 3% was ’04-’05 and north of 4% was ‘’97-’00. Many aspects of US infrastructure are in urgent need of attention, from roads to levees, electric transmission to water. Some investment here would spur growth, improve our quality of life and longer term well-being. Increased inflation, historically integral to growing economies, will help avert the dreaded deflationary spiral, and also help Congress navigate out from under the ever growing $20 trillion gross national debt.
On the other side of the coin, there are a number of things to watch for, akin to unintended consequences. As I noted, the value of the US$ has skyrocketed. A high US$ will be a drag on US multinationals’ earnings. It will also exacerbate the trade deficit and pressure GDP downward. The rising yield curve and higher interest rates will make credit more expensive, raising mortgage rates and slowing growth. Higher inflation may well push down the already elevated P/E ratio on the stock market. Unless earnings can reverse their malaise of the last few years, prices are ripe to revalue downward at the first hint of trouble. The flow of funds into stocks (out of bonds) has been pronounced. This means more investors are taking on more risk, at the very point in time when the risk of an unanticipated event is high, extremely high.
With so little facts to work with, markets have been jumping at shadows. My thought at this point is to underweight fixed income. I think rising rates will allow us to buy better yielding bonds. At the same time, bond mutual funds are slightly less attractive, as they behave poorly with the threat of higher rates. Stocks remain the highest potential-return asset class, though we should be wary of getting caught up in a momentum trade. Valuations are high, and the “tail-risk” present in the markets today is unquantifiable. Investors have shifted their focus to value stocks this year. Growth stocks, historically our preferred type of stock, have had a more difficult time this year. For example, technology and health care and many consumer stocks have been under pressure since the election. We are working hard to rebalance our holdings to best reflect our view of the present landscape.
Finally, we are preparing for year-end, and doing our best to limit realized capital gains. I think we have to be both patient, and attentive. We are long term investors, and before making strategic changes to our portfolios, I prefer to see some evidence of actual policy, footprints in the snow so to speak. If you like, please feel free to check in, and I can explain in greater detail.
Bruce Hotaling, CFA