By John Spear, CFA, USAA Mutual Funds Chief Investment Officer
As we approach the midpoint of 2017, investors are still trying to make up their minds on the Trump agenda – basically whether to keep hoping for results or to write it off. Whatever they end up deciding may have a sizable impact on how the second half of the year plays out.
We think it’s pretty safe to say that few believe the most optimistic vision, which drove asset prices immediately after the November election, will come to pass. This included real economic growth exceeding 3% annually, a large tax cut for individuals and companies, a wholesale rewrite of the regulatory regime and a massive investment in infrastructure.
The question now is which of these big targets may be hittable, and on what timeline. The administration has used executive orders to chop through some of the regulatory thickets – tax cuts and infrastructure come with a higher degree of difficulty. But if it starts to look like something might get done, some of that early optimism could return.
The Federal Reserve raised interest rates in June; it was the fourth hike in the tightening cycle that began in December 2015, and it came despite scant inflation and signs that the U.S. economy may be softening.
The Fed signaled another rate bump in the second half of 2017, but the market is not convinced it will happen – yields on the 10-year Treasury have dipped from 2.6% in mid-March to 2.1% in mid-June. If economic data continues to come in on the weak side, the Fed may play it safe. This scenario would support bond prices, and it would also fit our “low-ish for longer” outlook.
While the Fed is tightening, the eurozone and Japanese central banks are still in loosening mode via ultra-low rates and large-scale bond purchases – Figure 1 shows the Fed’s holding steady as Europe and Japan pile up more balance-sheet assets.
Later this year, the Fed plans to start slowly trimming back its $4 trillion in bond holdings. The deliberate pace makes sense to us -- moving too quickly would have risked a plunge in bond prices at the long end of the curve. Nonetheless, even a slow runoff could push down prices and push up interest rates.
ASSET CLASS OUTLOOK
Non-U.S. stock markets set the pace in the first half of 2017 (Figure 2). A number of key developed-market indices were close to all-time highs, while Japan’s Nikkei index was near a multi-decade peak.
The Treasury market appears to be responding to growing signs that the U.S. economy could be slowing – yields on longer-term Treasuries have fallen as many investors embraced haven assets.
U.S. stocks continued their strong performance, with the Standard & Poor’s 500 index further stretching already rich valuations in a low-volatility environment. Sharper-than-expected earnings growth contributed to the equity exuberance, as well as to tighter U.S. credit spreads.
The U.S. stock market has been unusually placid for a while – big moves up or down are so rare that their appearance makes for bold headlines. International markets are also calm. But just because markets have been docile doesn’t mean they’re going to stay that way. We believe investors should not be surprised to see more volatility going forward.
While we may be relatively late in the economic cycle and stock valuations are lofty, we don’t view U.S. stocks as being vulnerable to a large reversal any time soon. The S&P 500 has posted a number of record highs in 2017, the latest coming in mid-June, but the climb has been slow and without the sort of exuberance that suggests an impending top.
Valuation-wise, we think the price-to-earnings ratio for the S&P 500 is essentially at its upper bound – it’s hard to envision investors being willing to pay much more for a given dollar of profits. In our view, the likeliest catalyst that could push stock prices higher is companies producing more profits, and the best way to do that is stronger-than-expected revenue growth in 2Q and beyond. Tax cuts, if enacted, could also help.
Corporate fundamentals were good in the first quarter of 2017, but that’s compared to a weak 1Q a year earlier. Quarter-over-quarter comparisons will get tougher as the year progresses. Two sectors to monitor to determine how well the market is holding up are financials (gauge of credit demand) and technology (measure of corporate spending).
Over the past several years, the rationale for overweighting U.S. equities has boiled down to “there is no alternative,” as other non-U.S. developed markets struggled with deflation and emerging markets dealt with weak commodity prices and a slowing Chinese economy.
That storyline has been rewritten in 2017 – economic growth and corporate fundamentals in both DM (most notably the eurozone) and EM are fueling a strong upswing in share prices. And because those asset classes have not enjoyed the same sort of multi-year returns as U.S. equities, they remain relatively undervalued compared to U.S. stocks (Figure 3).
As long-term investors focused on relative valuation, we were early to this trade in our asset allocation portfolios – we have been overweight DM and EM stocks for several years in anticipation of narrowing performance between U.S. and global markets. We added to that overweight as we grew more confident in its staying power.
Risks are down, but not out. For DM, there are still open questions about bad debt at big banks and we worry a bit that a volatility spike in U.S. stocks could be contagious. For EM, a revived U.S. dollar could hurt, as could changes to U.S. trade policy.
Fixed income is not cheap, but it also doesn’t carry the rich valuations prevailing in the U.S. equity market. We don’t see a negative catalyst in the offing that suddenly changes the risk-reward dynamic, so we think bondholders can continue to pocket current income without worrying too much about a price plunge.
Ultra-tight spreads suggest U.S. credit may be overvalued, but we think there are several key reasons why it may be resilient for at least the next few quarters, and maybe longer.
First, improving corporate fundamentals stand to reduce default and downgrade risk. In terms of revenue and earnings growth, the first quarter of 2017 was the S&P 500’s best in five years, and the outlook for the rest of the year is good. Fundamentals are also improving in global markets.
Second, falling expectations for U.S. economic growth could cut inflationary pressures and thus the pace of Federal Reserve rate hikes.
And third, rock-bottom Treasury yields continue to push income investors toward credit – this trend has strengthened in tandem with corporate fundamentals. Inflows are not only domestic, but also from yield-starved investors overseas where interest rates are even lower (Figure 4).
After last year’s dramatic rebound, oil has steadily trended downward in 2017 on oversupply issues. The pace picked up after the Fed’s interest-rate increase in March and accelerated further in May after disappointing production news from OPEC. By late June, crude was in bear market territory and energy shares were in the tank. Demand for oil is growing, but the supply glut is growing faster. It’s hard to see what might reverse this trend over the near term.
Last year’s powerful tailwind from China that propelled industrial metals – including copper, nickel and iron ore – appears to have died down in 2017. Waning demand from the world’s largest consumer has pressed down on prices, and brimming inventories are likely to limit any near-term recovery for the metals or the miners.
Gold rallied close to $1,300 an ounce in May on U.S. political concerns before rolling over when the Fed’s June rate hike seemed assured. The metal’s performance is well ahead of gold-mining stocks – the lag for the equities is in large part due to cost pressures as well as problems facing specific mines. As a haven asset, gold could return to favor in the event of geopolitical turbulence or if global economic growth loses momentum.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are suited for you based upon your individual goals, objectives, risk tolerance and time horizon.
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