“My luck was so good I could do no wrong” Jerry Reed, When You’re Hot You’re Hot
Much like guitar-picker and singer Jerry Reed, we’re running out of superlatives to describe the markets’ returns thus far this year. All major assets had strong positive returns during the 3rd quarter, and U.S. equity markets reached new highs. Good Q-2 earnings (especially in the U.S.) and signs of synchronized global economic growth pushed stocks higher, led by emerging-markets equities. Stock prices primarily follow earnings growth, and growing GDP, declining unemployment and little sign of inflation or sharply rising interest rates also offer support. Low inflation led to moderated expectations for central-bank rate hikes, and helped both bonds (a ‘lower for longer’ redux) and risk assets, which look more attractive in this environment. Investors continue to ignore geopolitical events and murky policy, so stocks and bonds are currently poised to trend higher. Here’s a summary of Q3 results:
“When you’re hot, you’re hot…” Jerry Reed, When You’re Hot You’re Hot
Here are some ‘hot’ and ‘not so hot’ areas we’re reviewing:
Global growth: For the first time since the rebound from the Global Financial Crisis (GFC), the world’s economies seem to be moving in sync. The left-hand graph shows global composite PMI slowly but firmly trending upwards in expansionary readings (over 50 on the scale). The right-hand graph, from the OECD, indicates their highest reading on global real GDP growth since the rebound years following the GFC. Their estimates have recently been revised upward, and are approaching their pre-GFC average despite China’s slowing growth trend. While these are estimates, positive sentiment and corporate expansion of capital expenditures and employment trends may follow.
Growth stocks: In a strong YTD run following last year’s underperformance to value stocks, growth stocks have had a robust start to 2017. In the U.S., a focus on large-cap tech names has led a rotation away from value stocks, which were better performers last year partly due to a strong post-election run. This year, as policy uncertainty has befallen Washington, value favorites such as the banking sector have lagged technology and health care stocks. The value-growth spread is less pronounced with international stocks, but is also being partly driven by a focus on tech stocks, particularly in China. While earnings and valuations haven’t yet broken down, optimism is running high for these risk assets in a low-interest-rate environment.
“And when you’re not, you’re not” Jerry Reed, When You’re Hot You’re Hot
Yields: Simply put, yields are too low this late in a recovery. The ‘normalization’ process the Fed is undertaking will take some time, as it reverses years of supporting the U.S. economic recovery by raising short-term rates and reducing its huge balance sheet. Over-communicating these changes and a deliberate schedule of hikes and asset roll-offs have helped investors remain calm, but the fact remains that there is a great deal of debt still supporting risk-asset prices as well as credit yields (e.g. high-yield bonds). As the graph demonstrates, bond holders are not being compensated for holding longer-term bonds. How the Fed and the other key central banks manage the roll-off, and how the market absorbs future supply in the mortgage and Treasury markets, are important indicators of support for stocks and growth.
Wages: Much like yields, wage growth has not been as robust as expected or desired during the U.S. and international recoveries. This metric is carefully followed by the Fed and has an impact on corporate earnings. Despite cyclically low unemployment numbers, wages have not grown as quickly as in the past and, when adjusted for inflation, have been virtually stagnant for years. Some faster wage growth may help in a variety of economic areas and sentiment, but headwinds to wage growth seem rather persistent.
“Put all the money in and let’s roll ’em again” Jerry Reed, When You’re Hot You’re Hot
Global bond and stock markets are ‘hot.’ While we see no flashing stop lights on the immediate road ahead (12 to 18 months), investors’ continuing blasé reactions to geopolitical risk and historically low volatility give us some pause. We are placing our faith in a sensible rotational among assets and valuation levels, and central bankers’ ability to manage a slow and steady economic reflation. After all, bull markets rise on optimism, not pessimism.
As always, we welcome your comments and questions.
—Your Wealth Management Team at JJ Burns & Company
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