Three Key Thoughts:
- Better Growth Expectations Fading?
- Fed Staying Ahead
- Non US Markets Picking Up
The resurgent growth narrative (lower taxes + less regulation = improved growth) continued through much of the second quarter. For the first two months of the quarter, a small group of very large cap technology stocks dominated the returns of the market indices, causing some investors to see visions of 1999. As these technology stocks sold off in June, health care, industrial and financial stocks took over the market leadership, leaving market levels at or near all time highs at quarter end.
In many ways, the bond market’s second quarter looked much like the first. Treasury yields declined, spreads in credit sensitive sectors tightened further and non-dollar debt generally appreciated as the dollar weakened. The bond market also absorbed another one-quarter percent hike in the Federal Funds rate without much reaction.
Because short term rates were raised while long term rates were declining, the spread between short and long term rates narrowed further. This spread is something we will keep a careful eye on because further narrowing could be an indicator of economic weakness to come. The other indicator we are watching is the spread between high yield corporate bonds and comparable maturity Treasury bond rates. If this spread begins a sustained rise, this may also portend weakness in the equity markets and a potential recession on the horizon. Given that we are about eight years into this economic expansion, we need to be vigilant in looking for signs of future weakness.
Some of the stock market’s current buoyancy is based on expected fiscal stimulus from lower tax rates. With Obamacare repeal and replace on life support, keeping tax reform “revenue neutral” will be a much more difficult task. As a result, a meaningful reduction in tax rates is unlikely. On the plus side, reducing (or just not introducing new) regulation is something the administration has in its sights and could well make progress on.
Another restraint on growth will be tighter monetary policy. As we look at the Federal Reserve’s objectives, we see the table set for continued “normalization” of interest rates and reduction of the Fed’s balance sheet. The US economy is growing at or near its potential, inflation is just shy of the Fed’s 2% target and the employment picture is solid with unemployment well under 5% and monthly job additions pretty strong. As long as all three of these boxes (economy, inflation, jobs) stay checked, we believe the Fed will continue to raise rates gradually and will begin to reduce the size of its balance sheet according to the plan they laid out recently.
Speaking of the Fed, we have heard more chatter from Fed members recently with concerns about stock market valuations. While there are certainly pockets of excess valuation, we don’t believe the 1999 analogy is apt at this point for a couple of reasons. First, concentrations of value are not out of line with historical averages. Second, many of these highly valued companies are growing real earnings at high rates, justifying higher price to earnings ratios. However, we are far more concerned about excessive valuations of stocks in many large, slow growing companies. Many of these stocks have P/E ratios that are 4 or 5 times their growth rates – a very unattractive valuation – yet investors appear complacent. We think the Fed chatter is more likely to indicate that they are putting normalization of rates ahead of supporting markets.
Outside the US, North Korea is right where it wants to be – in the center of controversy over its nuclear capabilities. So far, there has been little but tough talk from both sides. China is the key to solving this problem - it will be quite interesting to see if President Trump and his team can work out a diplomatic deal that China will fully support.
Meanwhile, President Trump’s first meeting with Vladimir Putin seems to have mollified critics for now. That said, the surrounding G20 meeting provided much less enthusiasm for Mr. Trump’s America First agenda. Interestingly, this confab took place in the context of a growing view that many non US economies are improving quite nicely. And if you believe that policy is translated quickly into currency movements, then the still weakening dollar says a lot.
Stronger economies and currencies propelled non US stock markets to a very strong first half. We believe this may be the beginning of a longer term trend but only time will tell. Many of these markets have everything going for them (supportive central banks, increasing growth and reasonable valuations) except sentiment. And sentiment can change quickly with positive returns and supportive cash flows.
We have kept asset allocations relatively stable in client portfolios. While being cautious about deploying new cash, we have not reduced US equity exposures meaningfully despite a good first half of the year. We continue to believe that non US stocks provide a more compelling value proposition than US stocks and hold a substantial weighting. Finally, we continue to evaluate fixed income and alternative investment opportunities as returns from these areas have been disappointing. As a result, client portfolios contain somewhat more cash than usual.
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