- Economic growth has been strong, with several signs pointing to a robust expansion. This has helped boost corporate profits and lift stock prices, despite volatility earlier in the year. Escalating trade disputes threaten to slow growth, but we believe that recession risks are low.
- With the exception of U.S. equities, and growth stocks in particular, 2018 has been a rather disappointing year for asset prices. We do not believe that investors should abandon a well-diversified portfolio. We see attractive long-term opportunities in international stocks, and rising rates should reward bondholders over time.
- We believe that fixed income investors are not being adequately compensated for investing in longer maturity or lower quality bonds. We prefer bonds with short maturities and high credit quality in this environment.
- We continue to favor stocks over bonds, but rising rates have made fixed income investments a bit more attractive.
Ten years ago this fall, we were in the midst of a global financial crisis, precipitated by the collapse of investment bank Lehman Brothers. America held its collective breath as other formerly stalwart financial institutions stood on the brink of failure. Although the United States would officially exit the Great Recession in the summer of 2009, the effects of the financial crisis were felt for many years with painfully slow economic growth.
The economy has been anything but sluggish lately, with several signs pointing to a robust expansion:
- Second quarter GDP growth of 4.2%, well above the post-recession average of 2.3%
- Unemployment rate of 3.9%, near its lowest level since 2000
- Weekly jobless claims at their lowest level since 1969
- ISM Manufacturing index at its highest level since 2004
- Consumer confidence at its highest level since 2000
- Corporate profits at all-time highs and expected to grow 20% this year1
What a long way we have come. Just a few years ago there were widespread fears of persistently high unemployment rates and debt deleveraging leading to a possible deflationary spiral. Those fears have flipped completely, with concerns now of a labor shortage and inflation potentially running too hot. In fact, more companies are worried today about finding qualified employees than generating adequate sales, according to the National Federation of Independent Business (NFIB). (Figure 1)
Robust economic growth, along with corporate tax cuts, have helped boost corporate profits to record highs in 2018. This has helped lift stock prices, despite volatility earlier in the year. We continue to favor stocks over bonds, although rising rates have made fixed income investments a bit more attractive lately. As Figure 2 shows, the current yield on bonds with moderate credit risk is the highest it has been in years relative to the earnings yield (net income / share price) of the S&P 500®.
Economy Strong, but Monitoring Risks
While economic growth remains robust, escalating trade disputes threaten to slow it. The United States has recently applied tariffs to many goods imported into the country, and some countries, like China, have retaliated with tariffs of their own on U.S. goods. America is not a large exporter to China, so we do not expect a major hit to revenue for most U.S. firms (Figure 3) – although many farmers have been unfortunate victims of retaliatory tariffs on certain agricultural products. However, new tariffs on goods imported to the U.S. are likely to be felt by many American companies and consumers through higher costs. We believe that tariffs, along with a tightening labor market, could push inflation higher throughout the rest of the year and into 2019.
We will also be watching the midterm elections closely in November. A significant shift in power in D.C. could surprise investors, possibly creating uncertainty and volatility in the financial markets. However, we would not expect major legislative changes in that scenario, given there would be separate political parties in Congress and the White House.
Overall, the economy remains strong, and we believe that recession risks are low.
There is a saying on Wall Street that “bull markets don’t die of old age.” March 9, 2009 is the date often credited as the start of the current bull market. Based on that date, the current bull market recently became the longest in U.S. history, surpassing the market rally of the 1990’s. But like a baseball player during the Steroid Era, this record may come with an asterisk.
A bull market ends when the stock market declines 20% from its peak. Back in 2011, the S&P 500® experienced a 21% decline from its intraday high on May 2 and its intraday low on October 4. Yet, based on the days’ closing prices, the index only fell 19%, which technically kept the bull market alive.
Others argue that the current bull market didn’t really start until March 2013, since that is when the S&P 500 eclipsed its pre-financial crisis high. And while there may not have been a technical bear market, there have been multiple corrections, or declines of 10% or more along the way. In addition to 2011, there were market corrections in 2010, 2015, 2016 and early 2018. Perhaps the “aging” bull market isn’t so old after all.
U.S. Stocks On Top Once Again
While the U.S. stock market has seen tremendous gains since March 2009, international stocks have struggled in comparison. This year has been no exception, particularly for the emerging markets. (Figure 4) Slower-than-expected economic growth, fears of escalating trade disputes, and weaker currencies have all negatively impacted emerging market equities this year.
Indexes Used for Figure 4: 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
With U.S. stocks providing such stellar returns during the great American bull market, many investors may question the need for international equities at all. We do not believe that this is the time to abandon a globally diversified portfolio. History has shown an ebb-and-flow pattern between U.S. and international equity outperformance. (Figure 5) The U.S. stock market has been on top for an extended period, but this isn’t likely to last forever. Mean reversion is too powerful of a force to ignore. We continue to favor international stocks longer term, although our enthusiasm has been tempered near term as recent headwinds may persist for some time.
We believe that the long-term return potential for emerging market equities remains particularly attractive. But investors will need to buckle up as it may not be a smooth ride. Emerging market equities have always been volatile and will always be volatile – that is the nature of the beast. Last year, for instance, the MSCI Emerging Market index soared more than 34%, excluding dividends. This year it is down almost 10%. Reward does not come without risk. Or as Robert Arnott once said, "In investing, what is comfortable is rarely profitable."
Just as U.S. stocks have outperformed international stocks over the last several years, growth stocks have outperformed their value counterparts. That has been the case so far in 2018 too, with the Russell 1000 Growth index outpacing the Russell 1000 Value index by nearly 14 percentage points. Once again, we recommend that investors remain diversified. While growth stocks may continue their dominance for quite some time, note that the gap in performance between growth and value stocks has reached extreme levels. (Figure 6) Either “this time is different”, or we will see mean reversion at some point. We expect the latter.
Bonds: Staying Shorter and Safer
One consequence of the stronger U.S. economy has been rising interest rates. The Federal Reserve has continued to normalize short-term rates in response to a strong labor market and core inflation near its long-term target of 2%. The rise in interest rates has been a headwind for fixed income returns this year, as bond prices move opposite of rates.
Yet, higher rates are a positive development for bond investors longer term, as the initial pain of falling bond prices is rewarded with higher yields over time. The future returns from bonds are highly dependent on where yields sit today. (Figure 7)
While short-term interest rates are likely to continue marching higher this year and into 2019, we expect long-term rates to remain low relative to historical averages. Unlike short-term rates, which are largely controlled by the central bank, long-term rates are driven more by market forces. We expect the large demand for fixed income investments around the globe to keep somewhat of a lid on yields.
We believe that fixed income investors are not being adequately compensated for investing in longer maturity or lower quality bonds. The difference in yields between a 10-year U.S. Treasury note and a 2-year Treasury bill was less than 0.25% at the end of September. Additionally, the difference in yields between corporate bonds with the same maturity but different credit quality also remains low on average. As a result, we prefer bonds with short maturities and high credit quality.
The Bottom Line
The U.S. economy continues to thrive, providing a significant boost to corporate profits, which have generally lifted stock prices this year. But with the exception of U.S. equities, and growth stocks in particular, 2018 has been a rather disappointing year for asset prices. We do not believe that investors should abandon a well-diversified portfolio. We see attractive long-term opportunities in international stocks, and rising rates should reward bondholders over time. And as we were all reminded ten years ago, high-quality bonds can help stabilize portfolios in a falling market.
COUNTRY Trust Bank Wealth Management Team
- Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
- Kent Anderson, CFA - Portfolio Manager
- Jonathan Strok, CFA - Investment Analyst
- Chelsie Moore, CFA, CFP® - Manager, Wealth Management
- Todd Bunton, CFA - Portfolio Manager
- Austin Burant- Investment Analyst
1. Based on consensus earnings estimates from analysts for the S&P 500® index.
Jobless claims, or initial claims for unemployment, are calculated by the Department of Labor. An initial claim is a claim filed by an unemployed individual after a separation from an employer. When an initial claim is filed with a state, certain programmatic activities take place and these result in activity counts including the count of initial claims. According to the Department of Labor, the count of U.S. initial claims for unemployment insurance is a leading economic indicator because it is an indication of emerging labor market conditions in the country. However, these are weekly administrative data which are difficult to seasonally adjust, making the series subject to some volatility.
The Institute for Supply Management’s manufacturing index is based on data compiled from purchasing and supply executives nationwide. Survey responses reflect the change, if any, in the current month compared to the previous month. The PMI® is a composite index based on the diffusion indexes of five of the indexes with equal weights: New Orders (seasonally adjusted), Production (seasonally adjusted), Employment (seasonally adjusted), Supplier Deliveries (seasonally adjusted), and Inventories. A PMI® reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally declining. A PMI® above 43.3 percent, over a period of time, indicates that the overall economy, or gross domestic product (GDP), is generally expanding; below 43.3 percent, it is generally declining. The distance from 50 percent or 43.3 percent is indicative of the strength of the expansion or decline.
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 National Federation of Independent Business (NFIB) “Single Most Important Problem” data comes from the NFIB’s monthly “Small Business Economic Trends” report. The NFIB’s Research Center has collected Small Business Economic Trends Data with Quarterly surveys since 1973 and monthly surveys since 1986. Survey respondents are drawn from NFIB’s membership.
Earnings yield is the inverse of the price-to-earnings ratio, measuring earnings per share as a percentage of a stock’s price.
Moody’s Investors Service provides ratings to securities in order to provide investors with a simple system of gradation by which future relative creditworthiness may be gauged. Moody’s Aaa-rated obligations are judged to be of the highest quality, subject to the lowest level of credit risk. Its Baa-rated obligations are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.
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 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 Russell 1000® Growth Index is a subset of the Russell 1000® index that includes companies whose share prices have higher price-to-book ratios and higher expected earnings growth rates. The Russell 1000® Value Index is a subset of the Russell 1000® index that includes companies whose share prices have lower price-to-book ratios and lower expected long-term mean earnings growth rates. The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index.
The S&P 500® Value vs. Growth Index comes from the S&P 500 Value and S&P 500 Growth indexes, which are constructed by S&P Dow Jones Indices based on certain growth and value stock characteristics from the constituents of the S&P 500®.
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.
Duration is a measure of a security’s interest rate risk. It is based on the timing of cash flows received by an investor and expressed in years. Longer duration securities typically have higher price sensitivity to interest rate changes than shorter duration securities.
The long-term average return data in Figure 8 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.
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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.