Nuveen TIAA

Global equities roll on

Brian Nick, Chief Investment Strategist, TIAA Investments

Print

September 15, 2017

Click here for the downloadable version (PDF)

Quote of the week

“An investment in knowledge pays the best interest.” – Ben Franklin

The Lead Story: How would Ben Franklin assess this U.S. equity market?

Rumor has it that whenever the Founding Father was faced with making a key decision, he’d divide a piece of paper in two. On one side, he’d list the reasons for taking a course of action and on the other side, those against. Let’s apply a form of this strategy to assess whether the current bull market—history’s second-longest and second-strongest—will continue.

“For” — this rally has legs because:

U.S. corporate earnings should remain strong. We expect earnings from S&P 500 Index companies to grow by 6%-7% in the third quarter, only a slight deceleration from the year’s first two quarters. As long as earnings continue to grow, stock prices will find more room to increase.

Brian Nick, Chief Investment Strategist, TIAA Investments

Brian Nick - 140px

Article Highlights


Global growth should still improve. Economic data in the developed world, particularly the Eurozone, have consistently beaten expectations this year. China, another large piece of the global economic pie, has managed to keep growth stable as it attempts to contain the financial risks associated with rising debt levels. The gap between emerging- and developed-market growth rates, which fell to 1% in 2015, now appears primed to average 3% or more in the next several years.

Investors don’t like this bull market. Legendary investor Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We agree. Rather than embrace this equity market, investors are retreating from it. From July 1 through August 31, almost $22 billion has flowed out of U.S. equity mutual funds and exchange-traded funds while an astonishing $60 billion has moved into U.S. taxable fixed-income funds, despite their low yields.

“Against” – this rally’s days are numbered because:

Valuations are high. As the S&P 500 has returned more than 13% in 2017, its valuation has reached 17.6x consensus forward earnings over the next year, a level not seen since the Technology bubble. Today’s elevated multiples reflect a combination of optimism about U.S. earnings growth, a slight chance of tax cuts from Washington, and a lack of attractive alternatives (see: bonds). But valuations are a reasonably good guide for predicting longer-term market performance. High multiples have historically been associated strongly with subpar market returns in the ensuing years.

Fed changes are afoot. Janet Yellen may not win a second term as Fed chair when her term ends on February 3, and Stanley Fischer, the vice chair, has announced his resignation, effective next month. On top of that, the president has a number of other vacancies to fill. Although a 25 basis point (0.25%) December rate hike, which we expect, will not derail the rally, these leadership changes muddy the outlook for monetary policy after December. 


Hopes for pro-growth fiscal policy from Washington, D.C., are down to a flicker. December is shaping up to be a busy month for lawmakers, with showdowns likely over the budget, immigration, and other hotly debated topics. Will they also be able to draft and pass a robust tax bill, or other business-friendly measures, by year-end? Recent experience has told us to expect nothing from Washington as a base case, and it seems prudent to adhere to this rule until it is contradicted.

In other news: Global equities advance, while Treasuries falter

U.S. equity markets rebounded from the previous week’s decline. Investors got a whiff of the “reflation trade,” bolstered by August’s better-than-expected increase in consumer prices. They also breathed a sigh of relief as worst-case scenarios over Hurricane Irma’s economic damage appeared not to materialize. A North Korean missile launch did little to dampen the bullish sentiment. The S&P 500 rose 1.6% for the week en route to a series of record-high closes,  as it breached the 2,500 level for the first time.  Europe’s STOXX 600 Index (+1.5% in local terms) got a boost from surging bank stocks.    


The week’s risk-on mood hurt demand for U.S. Treasuries and other investment-grade fixed-income assets. The yield on the bellwether 10-year U.S. Treasury, which moves in the opposite direction as its price, moved up from its recent 10-month low of 2.05% to close at 2.20% on September 15. High-yield bonds, though, returned 0.21% for the week through September 14, bringing their year-to- date gain to 6.5%. We believe higher-quality high-yield bonds offer good value, as do similarly rated floating-rate loans.

Below the fold: Inflation finally heats up, and consumer spending cools

In a light week for U.S. data releases, gauges of inflation and consumer spending were the most revealing. Among the reports:

The Back Page: How to unwind a massive balance sheet—Get started

Through quantitative easing (QE), the Fed expanded its portfolio (from $800 billion to $4.5 trillion) by purchasing $3.7 trillion in Treasuries and mortgage-backed securities from 2008-2014. Since then, the Fed has maintained its balance sheet size by rolling over maturing securities and reinvesting their proceeds. 

On September 20, the Fed is expected to announce a balance-sheet reduction plan similar to the “go-slow” approach Yellen laid out in June. Under this scenario, the Fed will initially allow up to $10 billion of bonds to mature each month, with the cap incrementally rising to $50 billion until the Fed has reduced its balance sheet to its desired target. Estimates for the size of the final, slimmed-down portfolio range from under $2 trillion to more than $3 trillion. Even at this higher end, the Fed will still roll off an unprecedented $1.5 trillion in bonds. 


To the extent that QE’s cumulative effect was to push down long-term interest rates relative to short-term rates, this program should have the opposite effect. Treasury yields will be higher than they would have been had the Fed not decided to taper its holdings. But this process will unfold over several years, so we expect any rise in yields to also be gradual.

262200