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Market and Economic Update - Released 9/30/16

  • 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 

Key Takeaways

  • A further decline in interest rates has driven solid gains in both bonds and stocks so far this year.
  • Given near record-high stock prices and exceptionally low volatility, we believe that the stock market could be more susceptible to shocks going forward.
  • The elections this fall could add uncertainty to both the financial markets and the economy.
  • We believe that the low interest rate environment justifies equity valuations at least somewhat above historical norms, but it is difficult to find much value in the U.S. We see more attractive valuations overseas.
  • Solid growth in consumer spending has been somewhat offset by weak business investment, but overall the economy continues to improve.
  • We believe that interest rates are likely to remain lower for longer.
  • We continue to expect somewhat muted returns from both stocks and bonds going forward. Nonetheless, we believe that a well-diversified portfolio is the best avenue for long-term investors to achieve their goals.

The ancient Greek storyteller Aesop believed that a bird in the hand was worth two in the bush. Remarkably, there are some investors buying investments today that guarantee they will receive less money in the future. In other words, they are giving up that bird in the hand for less than one in the bush. Aesop probably would not have been a fan of today’s low yield environment.

In certain parts of the world, central banks have driven interest rates below zero through unprecedented quantitative easing. These and other non-economic buyers are pouring trillions of dollars into bonds with negative interest rates. While this has had a questionable effect on economic growth, it has almost certainly helped to drive up the prices of risky assets as other investors “reach for yield”.

With exceptionally low rates likely to continue, sluggish economic growth and relatively high asset prices, we continue to expect somewhat muted returns from both stocks and bonds going forward. Nonetheless, we believe that a well-diversified portfolio is the best avenue for long-term investors to achieve their goals.

Defensive is Expensive

For as volatile as the first half of the year was with China, oil and Brexit rattling the financial markets, the third quarter was exceptionally quiet. The S&P 500® strung together an incredible 43 straight trading days this summer without moving at least 1% in either direction. This came in spite of the looming presidential election in November.

Given near record-high stock prices and exceptionally low volatility, we believe that the stock market could be more susceptible to shocks going forward. While this view may argue for more defensive positioning within equities, we believe that some of the more defensive areas of the stock market are also the most expensive from a valuation perspective. That is one reason we remain slightly overweight more cyclical sectors of the stock market. In short, defensive looks expensive.

With extraordinarily low rates on many investment grade bonds around the globe, some income-oriented investors have turned to high dividend-paying, relatively stable sectors of the stock market in search of yield. While this has led to strong performance from areas such as utilities, Consumer Staples and Real Estate Investment Trusts, it has driven their valuations higher in the process.

The decline in interest rates has arguably been the main driver behind the overall stock market this year too. All of the gains in the S&P 500 so far this year can be attributed to expansion in the price to earnings (P/E) ratio rather than from earnings growth. The P/E ratio for the index is now well above its long-term average (Figure 1).

While valuations look a bit lofty here, we believe that the low interest rate environment justifies valuations at least somewhat above historical norms. However, we are struggling to find tremendous value in the U.S. stock market at this juncture. We believe that international stocks remain more attractive from a long-term valuation perspective.

Figure 1

 

Figure 2

Additionally, the S&P 500 remains in the midst of an earnings recession. Earnings for the index have declined year-over-year for seven consecutive quarters. Two major reasons for this decline have been low oil prices and a strong dollar. As both factors have stabilized, earnings growth could resume later this year and throughout 2017.

However, investors already appear to be pricing in very strong growth. According to Standard & Poor’s, consensus estimates are currently calling for 20% earnings growth in 2017 (Figure 2). This is likely too optimistic given the sluggish U.S. economy.

Slow but Steady

The U.S. economy has continued to grow in 2016, but its pace has been disappointing. Growth in consumer spending has been somewhat offset by weak business investment (Figure 3). But overall, the economy has been fairly stable.

Figure 3

A key reason for this is that, on average, the American consumer remains in its best shape in years. The housing market, another asset class that has benefitted from low interest rates, has continued to rebound (Figure 4), and the labor market has made additional strides. Job growth has been solid overall this year, and the official unemployment rate remains below 5%. The U-6 unemployment rate, which factors in discouraged job seekers and people working part-time for economic reasons, still remains somewhat elevated though at 9.7% (Figure 5). This indicates that there is still some slack in the labor market.

Figure 4

Figure 5

Meanwhile, we believe that the elections this fall could add uncertainty to both the financial markets and the economy. Populist sentiment has been rising across the globe and has been prevalent along the campaign trail from both major U.S. presidential candidates. This could have negative implications for many areas of the economy, including healthcare (especially drug manufacturers), banking, and multinational corporations with production overseas.

Lower for Longer

Amid somewhat sluggish economic growth, the Federal Reserve has held short-term interest rates near record lows this year. Last December, following its first interest rate hike since 2006, the Federal Open Market Committee projected that it would raise interest rates four additional times in 2016. Through the first nine months of the year, it has yet to hike rates once. The FOMC has also reduced its projections for short-term rates in the coming years (Figure 6).

Figure 6

Exceptionally low interest rates overseas are likely to keep a lid on rates here in the U.S. as well. Because of these factors, we believe that interest rates are likely to remain lower for longer. We also believe that fears of spiking interest rates and an impending bond crash are likely overblown. By focusing on high quality bonds and keeping duration relatively short, investors can guard against potential shocks.

Nonetheless, we do expect bonds to deliver somewhat muted returns going forward given the ultra-low interest rate environment. However, bonds still offer investors diversification benefits, and high quality bonds can provide a stabilizing force for portfolios, as investors witnessed in the first half of the year.

Summary

The exceptionally low rate environment and sluggish economy have made it a challenging environment for virtually all investors to find value amid nearly record-high asset prices. As a result, we continue to expect investment returns over the next five to ten years to be below their historical averages (Figure 7). However, we believe that a diversified portfolio of stocks and bonds still remains the best avenue for long-term investors to achieve their goals.

Figure 7

Definitions

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 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."

The S&P/CoreLogic Case-Shiller House Price index measures the value of residential real estate prices in 20 major U.S. metropolitan areas.

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.

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All information is as of the report date unless otherwise noted.
Past performance does not guarantee future results. All investing involves risk, including risk of loss.

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.