This has been a great year for the market as the August year-to-date return on the S&P 500 is 11.9%. This comes on top of 2016’s 12% advance. But not just equity investors are enjoying 2017 as the YTD return on the Bloomberg Barclays U.S. Aggregate Bond Treasury index is a solid 3.6%, enhanced by the fall in yield of the 10-Year Treasury bond, which recently was quoted at 2.17% versus 2.45% to start the year.
This drop in long-term yields is surprising given the Federal Reserve’s three 0.25% rate increases since last December. Further, the Fed might raise rates another 0.25% this December, is currently planning three more 0.25% increases in 2018, and has signaled it would like to begin shrinking its $4.5 trillion bond security portfolio sometime this fall.
Before the financial crisis of 2008-2009, the Fed maintained a bond portfolio of $1.5 trillion which gave it sufficient liquidity to perform its normal market operations. To drive down interest rates to spur economic growth during the recession, the Fed aggressively purchased U.S. government bonds and bond pools backed by housing mortgages. The shrinking of the Fed’s bond portfolio will mean less liquidity in the financial system and could have the impact of increasing borrowing costs. The Fed has signaled it will start slowly, shrinking its portfolio by $6 billion the first month and adding an additional $6 billion per month until hitting a cap of $30 billion per month. This seems sensible as it implies reducing the bond portfolio by less than 10% per year for the first few years. However, we are in uncharted waters.
In the face of this central bank tightening, why are yields falling? One possibility is the lack of inflation. In July, consumer prices grew 0.1% from the month earlier and only 1.4% over the past year. Inflation continues to run below the Fed’s target of 2% and if it continues to stay low will likely slow down the Fed’s tightening schedule.
Other possible reasons for the fall in yields are the lack of wage pressures and the lower odds of meaningful tax reform. Average hourly earnings for private-sector workers increased 3 cents in August to $26.39 per hour, up 2.5% over last year. Wage increases have been stuck in the low-to-mid 2% range for much of this expansion and do not show signs of accelerating in the face of low unemployment. 156,000 jobs were added in August and the unemployment rate ticked up 0.1% to 4.4%. With the unemployment rate this low, we should begin to see wage pressure. However, other factors seem to be holding workers’ pay back such as the rising labor force participation rate, demographics as higher wage baby boomers are replaced with lower paid twenty-year-olds, and higher productivity in certain sectors like retail, as more goods move to being sold online rather than stores. As an example, retail sales were strong in July, rising 0.6%, but sales at non-store retailers grew 1.3%, up 11.5% over last year.
The failure by the Republican majority to “repeal and replace” the Affordable Care Act calls into doubt the ability of the party to engineer meaningful tax reform. U.S. corporate tax rates remain the highest in the world, and both sides of the political aisle believe reducing them will improve the competitiveness of U.S. business and lead to job and wage growth. If tax reform is too modest or does not happen the economy will likely continue to grow slowly.
Growth in the second quarter picked up as Gross Domestic Product grew 3%, up from the first quarter’s 1.2% reading. Business investment advanced and was a meaningful contributor to growth. The third quarter could be a bit of a mixed bag as consumers are spending, but the cleanup and the start of rebuilding efforts for both Hurricanes Harvey and Irma could reduce growth by 1%-1.5%. While car sales are softer, the demand for housing is increasing as the large millennial generation begins to buy homes. There isn’t anything in the data to believe that growth will pick up much more than the 2%+ annual rate we have experienced since the 2008-2009 recession.
Expansions usually don’t die of old age. Often, there is an external shock or a misstep in government policy. Potential shock events include North Korea’s nuclear ambitions and continued terrorist activity. As for government policy, it is not positive for the equity market to see the Fed tightening. However, we are again in uncharted territory as real rates (nominal rates minus inflation) are still negative, creating room to continue to normalize.
The equity market saw its second consecutive quarter of double-digit earnings growth. S&P 500 companies grew sales 5.3% and EPS advanced 10.3% in the second quarter. Multinationals are doing particularly well as they are enjoying faster global growth combined with a weak dollar. While the dollar should stabilize we see much better growth in Europe, Japan, and continued growth from China. In fact, Europe is beginning to discuss ending its own bond-buying program, a sign of economic confidence.
Equity market valuations continue to look stretched. The forward 12-month P/E ratio for the S&P 500 is 17.4, about 23% higher than the 10-year average of 14.1 and 12% higher than the 5-year average of 15.5. Projected third quarter growth rates look modest with sales expected to advance 5.1% and EPS 4.9%. However, analysts expect double-digit EPS growth to return over the next several quarters. If this materializes the current valuation of the market won’t be a problem.
Daniel J. Boyle, CFA