Market Update
(all values as of 06.30.2020)

Stock Indices:

Dow Jones25,812
S&P 5003,100
Nasdaq10,058

Bond Sector Yields:

2 Yr Treasury0.16%
10 Yr Treasury0.66%
10 Yr Municipal0.86%
High Yield6.81%

Commodity Prices:

Gold1,798
Silver18.55
Oil (WTI)39.61

Currencies:

Dollar / Euro1.12
Dollar / Pound1.23
Yen / Dollar107.39
Dollar / Canadian0.73
 

The Sustainability of a Global Upswing

 

The S&P 500 Index continued to move higher in the third quarter of 2017, because domestic and global growth are reaccelerating. Profits from corporate earnings and GDP growth are intertwined, and the U.S. economic output grew at a 3.1% annual rate in the second quarter of 2017, the best quarterly rate of growth in two years. The U.S. economy remains stable with steady job growth, a rising stock market, and little inflation. According to survey data from the Purchasing Managers’ Index (PMI), which provides a useful indication of GDP’s direction, growth in the third quarter should also be strong. Based on market exchange rates, the global GDP growth rate for the third quarter of 2017 is estimated by J.P. Morgan to have been around 3.8%, which might be higher than the U.S. third quarter GDP estimates. This is the highest growth rate recorded since mid-2010.  The positive economic data has been good for equity and credit markets, lifting both earnings and earnings forecasts.  We expect that this constructive environment—improved growth, low inflation, and relatively loose financial conditions—will continue over the short-to-medium term. Looking forward, we see geopolitical tensions (particularly in North Korea), the risk of monetary policy mistakes, a failure to raise the debt ceiling, and potential protectionist measures as the biggest risks to market stability.

Core inflation has been undershooting the Phillips Curve, which assumes the inverse relationship between inflation and unemployment, giving the Federal Reserve some hesitancy in raising interest rates by 0.25% in December of 2017. The U.S. Federal Reserve policy acknowledges some downside risks to its goal of price stability and may be undershooting inflation. Although the Federal Reserve has raised rates four times since 2015, the consensus opinion is that more tightening is warranted as bond yields appear too complacent about growth. The Federal Reserve will also start to reduce its balance sheet this October, a quantitative easing (QE) in reverse. While the process will begin slowly, once begun it will accelerate on autopilot between 2022 and 2023. The Federal Reserve has detailed a pace of mortgage backed securities (MBS) runoff of $4 billion a month rising to $20 billion a month by the end of next year and $6 billion a month of Treasuries (TSY), rising to $30 billion by next year. The Federal Reserve is taking great precautions to send a smooth message to investors. To put the Federal Reserve policy in perspective, the $6 billion per month of initial unwinding is approximately one fifth of the average monthly maturities over the next year.

In Europe, growth has not been hampered by the euro’s strength. Unemployment across the Eurozone is at eight-year lows, while manufacturing leading indicators are at six-year highs. There is now widespread acceptance that real activity growth in the Eurozone and Japan has been much firmer than originally expected this year.  The European Central Bank (ECB) is beginning to discuss tapering for 2018 while the Bank of England (BOE) is considering an interest rate hike.  European corporate earnings are in the early stages of recovery. Japan’s recovery continues as the weak yen has helped exports. China appears stable although the yuan strength softens Chinese demand for foreign currency, including U.S. Treasuries.

 

The G7 economies are finally reaccelerating from a 1.8% average annual growth the rate over the 2010-2017 post crisis-period, even when the combined central banks afforded the markets about $6.2 trillion of excess liquidity with their accommodative monetary policy.  The most recent phase of the equity bull market has fundamental support, as consumer confidence continues to support earnings gains. There is still pent-up capex demand in the economy, particularly in defense and infrastructure. Manufacturing has expanded at a torrid pace in the third quarter of 2017. Corporate earnings are projected to grow by roughly 4% and 9% in 2017 and 2018 respectively. The rally continues despite no major legislative accomplishments. Equity markets remain solid investment choices given these assumptions. The U.S. economy has never had a recession with corporate profits rising.

Inflation will not move higher without wage increases, which remain stable. The present inflation backdrop is significant as it will likely sustain the corporate sector’s pricing power gains, suggesting that the market has a long way to rise.  The interest rates on the U.S. 10-Year Treasury have not risen significantly since bottoming during the 2008-2009 recession and financial crisis. The last stretch of rising rates was just after June 2016 Brexit vote, when the yield of the 10-Year Treasury Note hit an all-time low of 1.37%. It subsequently hit a two-year high after the November 2016 presidential election of 2.60% and has ranged between 2.2% and 2.5% throughout most of 2017. The current 10-Year Treasury rate is 2.3%. In the 1990s, a 10-Year Treasury note returned close to 6.7% per year versus a 2.3% yield now, about a 440 basis points drop in income for 10-Year Treasury holders. Bond investors now face two challenges. The first is relying on bonds for cash flow presents challenges to generating a robust income. Secondly, if rates rise, the prices of existing bonds will fall. While the risk of rising interest rates is important, the risk of rates remaining low for an extended period of time is more significant.

From a broad geopolitical perspective, the main financial market risk appears to be a possible escalation between the U.S. and North Korea.  However, investors appear to be growing desensitized to the ongoing back and forth.  A full-scale war between the countries appears unlikely, but a political crisis or even a small-scale skirmish could rattle global markets.  There are some indications that the U.S. and North Korea have held unofficial diplomatic talks behind the scenes.  This implies that North Korea may be under enough pressure to ease off on its aggressive actions.

For most of 2017, equities and other risk assets have been pushed higher by a three-legged stool: solid earnings growth, low bond yields and surprisingly depressed market volatility.  Overall we have a positive view toward the global economy.  Most leading indicators are in a positive territory, consumer spending is solid and capital expenditures appear to be on the rise.  And in the United States, we may see a boost next year in the form of long-awaited tax reform.