Brian Nick, Chief Investment Strategist, TIAA Investments
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.
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:
Buoyed by rising gas process, the Consumer Price Index jumped 0.4% in August—its biggest one-month gain since January—lifting its year-over-year increase to 1.9%. “Core” inflation, which excludes food and energy costs, rose 0.2% in August and 1.7% over the prior 12 months, where it has stood for four consecutive months.
Retail sales unexpectedly dropped 0.2% in August, and July’s sales were revised downward to 0.3% instead of the previously reported 0.6% rise. It will take some time for markets to parse out the effects from hurricanes Harvey and Irma from cyclical late-cycle trends. As a result, it’s difficult to tell if last month’s disappointing reading is the beginning of a trend or merely a “blip.”
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.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of TIAA Global Asset Management, its affiliates, or other TIAA Global Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.
The investment advisory services, strategies and expertise of TIAA Investments, a division of Nuveen, are provided by Teachers Advisors, LLC and TIAA-CREF Investment Management, LLC. Securities offered through Nuveen Securities, LLC.