- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Jeff Clark, CFA, CFP® - Manager, Investments & Wealth Management
- Kent Anderson, CFA - Senior Investment Officer
- Andy Finks, CFA - Investment Officer
- Todd Bunton, CFA - Investment Officer
- Chelsie Moore, CFA, CFP® - Investment Officer
- Jonathan Strok, CFA - Investment Associate
Our COUNTRY Trust Bank® team’s latest report covers their outlook for the economy, stock market and interest rates, along with thoughts on market volatility.
- The stock market was volatile but ultimately finished the first half of 2016 in the black as the S&P 500® index rose 2.7%.
- Bonds posted solid gains as interest rates fell around the globe.
- The U.S. economy grew at a modest pace, a trend we think will continue.
- The United Kingdom voted to the leave the European Union, jolting financial markets in late June.
- Corporate profits continued to decline, but we believe there could be some relief in the second half of the year.
- We continue to favor stocks relative to bonds, although less enthusiastically than in the past.
- We believe that investors should prepare for a future of lower returns relative to historical averages from both stocks and bonds.
According to multiple sources, the presumptive nominees for both major political parties are currently scoring historically unfavorable ratings.1 So, when Americans head to the polls to elect a new president this fall, many will grumble over choosing between what they consider to be two unappealing candidates. As asset allocators, we find ourselves facing a similar conundrum, forced to choose between what we consider to be a couple of less-than-ideal options. Neither of the two major asset classes – stocks nor bonds – appear poised for robust gains in the near term. The S&P 500® is trading near all-time highs despite declining corporate profits. Meanwhile, interest rates remain stuck near all-time lows, with investment grade securities offering miniscule yields.
Given our view of the investment landscape, we continue to lean towards equities, although we find it difficult to be enthusiastic for our preferred candidate. In either case, we believe that investors should prepare for a future of lower returns relative to historical averages from both asset classes. Despite our tempered outlook, we believe that a diversified portfolio of stocks and bonds still remains investors’ best avenue to achieve their long-term goals.
Additionally, Britain’s surprising vote to exit the European Union only increases our view that the markets are likely to remain volatile throughout the remainder of 2016 with muted overall returns.
‘Brexit’ Creates Uncertainty
On June 23, the United Kingdom voted to leave the European Union, an economic and political bloc of 28 European nations. The announcement jolted financial markets around the globe, as Britain’s impending exit creates a great deal of economic and political uncertainty. The move sets off a lengthy and potentially messy disentanglement from the E.U., including renegotiations of trade terms. There are also questions now about the potential survival of the European Union itself, as Britain’s “declaration of independence” could embolden further disintegration efforts across the E.U. All of this uncertainty could lead to a taming of “animal spirits” and increased volatility in financial markets. It could also drive a further strengthening of the U.S. dollar, thereby putting pressure on U.S. exports and corporate profits.
Britain’s vote to leave the EU creates both economic and political uncertainty.
While we agree that the impact on the global economy is unclear at this point, we believe that the impending exit has significantly greater repercussions for European markets than our own. The implications for the U.S. economy should be much less severe as the U.K. is simply not a major export market for the United States. Furthermore, economic data suggests that the U.S. economy continues to grow, albeit at a sluggish pace.
Sluggish Growth Continues
The U.S. economy officially exited2 the Great Recession in June 2009. Since then, the common refrain to describe the recovery has been “sluggish”. That description still remains appropriate in 2016 (Figure 1). According to the Bureau of Economic Analysis, first quarter gross domestic product increased at just a 1.1% annualized clip, although second quarter GDP estimates are tracking higher.3
While growth has been far from robust, we see low risk for a major recession on the horizon. Many of the signs that typically accompany late cycle economic growth remain absent, including a sense of euphoria that often permeates through the economy. Additionally, credit does not appear to be tightening, as is often the case heading into a recession. Inflation remains fairly low too, although we believe this could accelerate a bit in the second half of the year.
The U.S. economy continues to grow, albeit at a sluggish pace.
We also continue to see many positives for the U.S. consumer. Despite a markedly weak jobs report in May, the labor market remains solid. At 4.7%, the unemployment rate is at its lowest level since 2007 while average hourly earnings are growing at a decent clip (Figure 2). The housing market also continues to recover as interest rates remain near historic lows. This is good news for our consumption-based economy. Nonetheless, with the last recession now more than seven years behind us, we believe that the economy is likely moving closer to late cycle.
Meanwhile, global economic growth remains subpar, and the recent Brexit announcement isn’t going to help nudge it forward. China, a major global economic growth engine, continues to slow as investment growth has fallen to its lowest rate in 16 years.4 Despite this, oil prices have roared back to the upper-$40s after plummeting below $30 per barrel earlier in the year. The recovery in crude prices should ease significant strains for many oil exporting countries and reduce global recession risks, in our opinion. It should also ease the strains on corporate profits here at home.
Sideways Market Continues
While the economy has continued to grow modestly, corporate profits have stalled out the last several quarters. That is one reason why the stock market has been flat for nearly two years now (Figure 3). Earnings for the S&P 500 have fallen for six straight quarters, marking its longest stretch of declining profits since the Great Recession.
While earnings are currently mired in a recession, we believe that there could be some relief later this year. Two of the biggest headwinds for U.S. corporate profits – low oil and the strong dollar – have diminished somewhat this year. Falling oil prices dramatically reduced earnings in the energy sector and were a major contributor to the decline in overall corporate profits the last several quarters. As noted above, crude prices have reversed course and are well off their lows from earlier in the year. A strengthening U.S. dollar also squeezed corporate profits. While the greenback has rallied in the wake of Brexit, it still remains below its 2015 highs. These factors should provide relief to earnings in the second half of the year.
Nonetheless, despite nearly two years of sideways trading, the stock market still does not look like much of a value to us. Even after the recent Brexit-induced pullback, the S&P 500 is up nearly 16% from its February 11 low. Based on current consensus estimates, the index is trading at more than 16 times forward twelve month earnings.5 That is a bit above its historical average. However, we believe that the low interest rate environment justifies valuations above historical norms (Figure 4). We also note that bear markets typically do not appear without an economic recession. Even a sluggish U.S. economy should provide some support for equity prices.
We believe that low interest rates justify equity valuations above historical norms.
However, we expect the bumpy ride in equity markets to continue. A key theme of ours heading into 2016 was to expect greater volatility and heightened uncertainty in the stock market. That was certainly the case in the first half of the year. Given the economic and political uncertainty surrounding Britain’s vote to leave the E.U., we do not see this flat but volatile market ending anytime soon either.
We expect heightened volatility in equity markets to continue.
Despite clouds hanging over much of the international markets, we believe the long-term outlook for international stocks looks brighter than for stocks here at home. A major reason for this is because after several years of underperformance (Figure 5), we believe that equity valuations are much more attractive overseas than in the United States, especially when adjusted for the business cycle. While volatility is likely to continue in international markets, we believe investors will be rewarded for their patience.
Interest Rates: Lower for Longer
Amid the volatility in equity markets this year, bonds have once again provided a safe haven for investors. Despite near record low interest rates, fixed income securities have delivered solid returns year-to-date (Figure 6). Credit spreads have tightened this year too after widening considerably earlier in the year.
Indexes used for Figure 6: U.S. Treasury Bonds – Bank of America Merrill Lynch Treasury Master Index, U.S. High Yield Bonds – Bank of America Merrill Lynch U.S. High Yield II Index, U.S. Investment Grade Bonds – Citigroup Big U.S. Broad Investment Grade Index
We believe the huge demand for high quality fixed income securities is likely to keep interest rates “lower for longer”. Additionally, the Federal Reserve appears to be in no rush to raise short-term rates. Back in December 2015, following its first rate hike in nine years, the central bank projected four additional rate increases in 2016. After a first half of no rate hikes, that number is now down to two.6 The recent Brexit news could also very well push out rate hikes even further. Based on CME Group’s ‘FedWatch Tool’, the market recently placed less than a 1 in 7 chance of any rate hike at all in 2016, with around a 6% chance for a rate cut this year.7
We believe interest rates are likely to remain “lower for longer”.
Another factor likely to keep a lid on interest rates here at home is negative yields overseas. Central banks in several developed markets outside of the U.S. continue to drive rates below zero in an attempt to stimulate their economies (Figure 7). These negative yields aren’t just at the short end of the yield curve either. Rates are currently below zero on 10-year government bonds in Japan, Germany and Switzerland. Incredibly, Switzerland’s 30-year government bond yield recently fell into negative territory.
Compared to those rates, U.S. Treasuries don’t look too bad for fixed income investors. However, with interest rates this low and credit spreads fairly tight, bonds are almost certainly going to deliver lower returns going forward relative to their historical average.
Given our outlook, we continue to favor equities relative to bonds, although less enthusiastically than in the past. Despite a stock market that has essentially traded sideways for two years, equities still do not look particularly cheap to us. Yet, while high quality bonds may offer investors safety, they don’t offer much in the way of yields. We also view recession risks as low and expect continued modest growth in the U.S. economy, which should help support stock prices.
We continue to favor stocks over bonds but are less constructive than in the past.
As we stare at our ballot of investment options, we are not particularly enthusiastic about either candidate. We believe that investors should prepare for a future of lower returns relative to historical averages from both asset classes (Figure 8). Despite our tempered outlook, we believe that a diversified portfolio of stocks and bonds still remains investors’ best avenue to achieve their long-term goals.
1. CNN, FiveThirtyEight.com
2. The National Bureau of Economic Research
3. The Federal Reserve of Atlanta’s ‘GDPNow’ forecasted second quarter GDP growth of 2.6% as of July 1, 2016.
4. The Financial Times
5. Standard & Poor’s
6. From the Federal Reserve’s ‘Summary of Economic Projections’ on June 15, 2016.
7. Based on CME Group’s ‘FedWatch Tool’ on June 30, 2016.
The S&P 500® Index is an unmanaged index that contains securities typically selected by growth managers as being representative of the U.S. stock market. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.
The STOXX® Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
The Nikkei 225 index is a price-weighted equity index, which consists of 225 stocks in the 1st section of the Tokyo Stock Exchange.
The Bovespa Index is compiled as a weighted average of a theoretical portfolio of stocks designed to gauge the stock market’s average performance, tracking changes in the prices of the more actively traded and better representative stocks of the Brazilian stock market.
The Shanghai Stock Exchange is a capitalization index of all A-shares and B-shares that trade on the Shanghai Stock Exchange in China.
The Bank of America Merrill Lynch Treasury Master Index tracks the performance of U.S. dollar denominated sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion. Qualifying securities must have at least 18 months to final maturity at the time of issuance.
The Bank of America Merrill Lynch U.S. High Yield II Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Index constituents are capitalization-weighted based on their current amount outstanding times the market price plus accrued interest.
The Citigroup US Broad Investment-Grade Bond Index tracks the performance of US Dollar-denominated bonds issued in the US investment-grade bond market. Introduced in 1985, the index includes US Treasury, government sponsored, collateralized, and corporate debt providing a reliable representation of the US investment-grade bond market.
The price-to-earnings ratio is a valuation ratio of a company's current share price compared to its per-share earnings (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). Also sometimes known as "price multiple" or "earnings multiple."
Earnings yield is the inverse of the price-to-earnings ratio, measuring earnings per share as a percentage of a stock’s price.
The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Federal Open Market Committee, which is the primary monetary policymaking body of the Federal Reserve, sets its desired target range.
Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis
Investment management, retirement, trust and planning services provided by COUNTRY Trust Bank®.
Past performance does not guarantee future results. All investing involves risk, including risk of loss.
All information is as of the report date unless otherwise noted.
This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.
Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies, and they may be expected to do so in the future.
Stocks of mid-capitalization companies may be slightly less volatile than those of small-capitalization companies but still involve substantial risk and they may be subject to more abrupt or erratic movements than large capitalization companies.
International investing involves risks not typically associated with domestic investing, including risks of adverse currency fluctuations, potential political and economic instability, different accounting standards, limited liquidity and volatile prices.
Fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and nonrated securities present a greater risk of loss to principal and interest than higher-rated securities.
Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.
All indexes are unmanaged and returns do not include fees and expenses associated with investing insecurities. It is not possible to invest directly in an index.