- Both stock and bond investors felt the gravitational pull of higher interest rates in the first half of 2018.
- The current economic expansion that started in the summer of 2009 just became the second longest in U.S. history. We think that it still has room to run. However, we are seeing signs that the expansion is in or near the later innings.
- We continue to favor equities slightly over fixed income, due in part to outstanding corporate earnings and more reasonable stock valuations. However, higher rates have made bonds a bit more attractive to us.
- We continue to like international equities long-term, as the wide valuation gap between domestic and overseas stocks isn’t likely to persist forever. We are also maintaining a bias towards shorter and safer bonds amid the near-term threat of rising rates and narrow credit spreads.
“Every time the risk-free rate moves by one basis point – by 0.01% – the value of every investments in the country changes.... [T]he effect – like the invisible pull of gravity – is constantly there.” – Warren Buffett
Both stock and bond investors felt the gravitational pull of higher interest rates in the first half of 2018. With the job market at or near full employment and inflation inching up, the Federal Open Market Committee (FOMC) of the Federal Reserve (a group of 12 people, most of whom you’ve never heard of) has been raising interest rates off exceptionally low levels.
Despite otherwise strong fundamentals, including solid economic growth and stellar corporate profits, the stock market has been essentially flat so far this year. Rising rates have been a big reason why. We continue to favor equities slightly over fixed income, as the economy remains on relatively strong footing and has more room to run. However, higher rates have made bonds a bit more attractive to us.
Economy Strong, But Can It Get Much Better?
The U.S. economy experienced solid growth throughout the first half of the year. The labor market continued to tighten, with the unemployment rate reaching its lowest level since 2000 at 3.8%. A sub-4% unemployment rate is rare territory for the U.S. economy. The more comprehensive U-6 unemployment rate, which factors in people working part-time for economic reasons and those marginally attached to the labor force, including discouraged job seekers, is also near its lowest level since the early 2000s. The tightening labor market has driven up wages a bit, but the pace of growth remains puzzlingly slow. (Figure 1)
Corporate tax cuts, combined with robust business confidence, have led many firms to increase capital expenditures1, which bodes well for future economic growth. Forecasts for GDP growth in the second half of the year remain bullish, and consumer confidence remains near all-time highs. (Figure 2) Recession risks appear low.
Along with a tighter labor market and stronger growth prospects have come higher inflation expectations and interest rates. These forces pulled on both stock and bond prices in the first half. On the plus side, rates on savings and money market accounts have finally improved – a trend that should continue throughout the year.
The current economic expansion that started in June of 2009 just became the second longest in U.S. history, eclipsed by only the expansion of the roaring 1990s. We think that it still has room to run. The expansion has been long only on a calendar basis – aggregate growth has been modest. However, we are seeing signs that it is in or near the later innings, including:
- Rising interest rates (albeit from very low levels)
- Flattening yield curve
- Accelerating inflation (but still relatively tame)
- Labor market near full employment
Legendary investor Sir John Templeton once said, “[b]ull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We are probably somewhere between optimism and euphoria right now. And while the bull market may be in the later innings, late cycle stock market returns can be very strong.
Earnings Growth Outstanding
The S&P 500® was volatile but essentially flat in the first half of 2018. The modest gains were driven solely by earnings growth as the price to earnings (P/E) ratio declined significantly – from nearly 19x forward earnings at the beginning of the year to around 16x today. This contraction was driven by higher interest rates, inflation fears, and geopolitical concerns, especially the threat of escalating tariffs.
Small cap stocks fared much better than their large cap counterparts, with the small cap Russell 2000® index gaining approximately 7%. Growth stocks once again outperformed value stocks, which has been a common theme for quite some time – and one that cannot go on forever, in our opinion. Domestic equities beat international equities, with emerging markets particularly weak. The divergence in returns among equity styles this year is a good reminder of the importance of diversification. (Figure 3)
Indexes Used for Figure 3: US Large Cap Stocks – S&P 500, US Small Cap Stocks – Russell 2000, International Developed Stocks – MSCI EAFE Index, Emerging Market Stocks - MSCI Emerging Markets Index
Despite meager returns in the first half for the S&P 500, the earnings picture looks outstanding. More than three-fourths of companies in the index beat consensus expectations for both revenue and earnings in the first quarter, with firms posting their strongest top- and bottom-line growth rates since 2011, according to FactSet. The recently-enacted corporate tax cuts have certainly helped boost bottom lines, but strong earnings growth hasn’t been all about lower taxes. Revenues have been growing at a healthy clip for most sectors, due in large part to a stronger global economy.
Analysts have also revised their earnings estimates higher for future quarters, which is a positive sign. Based on current consensus estimates, earnings for the S&P 500 are expected to soar 20% this year and another 10% next year. If these expectations materialize (a considerable “if”, but entirely feasible), then this would put 2019 earnings at $177 “per share”, or about 15.6x the current value of the S&P.
The trailing P/E ratio would have to contract quite a bit further just for the stock market to remain flat over the next 18 months. This is certainly possible, particularly if rates continue rising, but strong earnings growth should provide support for stock prices. Valuations are more reasonable today than at the beginning of the year. But whether they expand, contract, or stabilize – which is a big determinant of stock returns short term – depends on a number of variables that are very difficult to predict.
While international stocks have underperformed U.S. stocks so far this year, they still look attractive to us longer term. Most of the developed and emerging economies do not appear to be in the late stages of economic expansion like the United States. The wide valuation gap between domestic and international stocks is also unlikely to persist forever. But patience will be required, as short-term headwinds for overseas equities could continue, including a stronger U.S. Dollar, decelerating growth in many international economies, and political risks in the EU.
Rising Rates Hurt Bond Returns, For Now
The FOMC increased the federal funds rates twice in the first half of the year (and seven times since 2015), and current expectations are for one or two additional 0.25% hikes later this year. This would put the fed funds rate between 2% and 2.5% by year end – its highest level in over a decade.
While long-term rates also increased in the first half, they did not rise at the same pace. The difference in yield between short-term and long-term rates shrunk, thereby flattening the yield curve. This is something that we are monitoring closely, as an inverted yield curve (where short-term rates are higher than long-term rates) has preceded recessions in the past. (Figure 4) We continue to favor short-term bonds given the relatively flat yield curve.
We also continue to prefer high quality bonds in this environment. While credit spreads (the difference in yields between bonds of the same maturity but different credit quality) have widened so far this year, they remain relatively tight by historical standards. High quality bonds also provide a stabilizing force to portfolios when stock market volatility climbs.
Rising rates hurt bond returns in the first half, with the Bloomberg Barclays US Aggregate Bond Index down over 1.5%. There is a silver lining though. Higher rates mean that investors are able to reinvest their coupon and principal payments at higher yields over time. And the higher yields go, the less sensitive bond returns are to changes in rates, all other things being equal. So the impact of bond price fluctuations from a rising rate environment can be more than offset by staying invested over the long term. But expect continued pressure on bond returns near term if rates continue to rise.
The Bottom Line
Economic growth has been solid, and corporate earnings have been outstanding. But rising rates, inflation fears and geopolitical concerns, especially tariffs, have kept a lid on equity returns so far in 2018. Valuations are now more reasonable than they were at the start of the year, but that doesn’t mean they won’t contract further, especially if rates continue to climb or trade wars escalate.
Rising rates have hurt bond prices, but the increase in yields have made them a bit more enticing. We are maintaining a bias towards shorter and safer bonds amid the near-term threat of rising rates and narrow credit spreads.
Investors have long enjoyed the anti-gravitational force of rock-bottom interest rates on asset prices. This era could be ending. But this shouldn’t be a reason for investors to panic. Economic fundamentals have been strong and should help to offset the pull of higher rates on equity prices. For patient bond investors, higher rates are a welcome reprieve from the historically low yields of the post-Great Recession world. (Figure 5)
COUNTRY Trust Bank Wealth Management Team
- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- 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 Analyst
- Austin Burant- Investment Associate
1. According to an article in The Wall Street Journal from May 16, 2018, titled “Capital Investment Soars at Firms”, capital spending by companies in the S&P 500 is expected to have jumped 24% in the first quarter of 2018 from a year earlier, marking its fastest increase since 2011, according to data from Credit Suisse.
The U-6 unemployment rate is a measure of labor underutilization. It factors in all unemployed persons, plus all persons marginally attached to the labor force (those who want to work, are available for work, have looked for work in the last 12 months, but who are not currently looking for work for various reasons), plus persons working part time for economic reasons (involuntary part time), as a percent of the labor force plus all persons marginally attached to the labor force.
The Conference Board Consumer Confidence Index® is designed to represent the health of the U.S. economy from the perspective of the consumer. The index is based on consumers’ perceptions of current business and employment conditions, as well as their expectations for six months in the future.
The S&P 500® Index is an unmanaged index consisting of 500 large-cap stocks. Since it includes a significant portion of the total value of the market, it also considered representative of the 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 which compares a company's current share price with its earnings per share (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be derived from the estimates of earnings expected in the next four quarters (projected or forward P/E). The ratio is also sometimes known as "price multiple" or "earnings multiple."
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small cap opportunity set. 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 MSCI EAFE Index is broadly recognized as the pre-eminent benchmark for U.S. investors to measure international equity performance. It comprises the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging market countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.
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.
The yield curve plots the interest rates of similar-quality bonds against their maturities. The most common yield curve plots the yields of U.S. Treasury securities for various maturities.
Credit spreads measure the difference in yields between bonds with the same maturity but different credit quality.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the USD-denominated, investment-grade, fixed rate, taxable bond market of securities. The Index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS sectors. It is not possible to invest directly in an index.
The long-term average return data in Figure 5 comes from Morningstar. The long-term annual return for each asset class is the compound average annual return from the period from 1926 through 2016. Stocks are represented by the Ibbotson® Large Company Stock Index. Bonds are represented by the five-year U.S. government bond. Cash is represented by the 30-day U.S. Treasury bill. Balanced Portfolio is representative of an investment of 50% Stocks and 50% bonds rebalanced annually from 1926 through 2016. These returns are for illustrative purposes and not indicative of actual portfolio performance. It is not possible to invest directly in an index.
Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.
FactSet provides computer-based financial data and analysis for investment professionals worldwide. It consolidates data on global markets, public and private companies, and equity and fixed-income portfolios.
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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 in securities. It is not possible to invest directly in an index.