Stocks Steady Down, for the Moment
After weeks of struggling, global equities stabilized last week. In the U.S., the S&P 500 Index rose 2.08% to 1,961, the Dow Jones Industrial Average climbed 2.05% to 16,433, and the tech-heavy Nasdaq Composite Index advanced an even stronger 2.97% to end the week at 4,822. Meanwhile, the yield on the 10-year Treasury rose from 2.13% to 2.19%, as its price correspondingly fell.
While investors caught a bit of a breather last week, volatility remains elevated. And although the bumpy ride is expected to continue, creating challenges for investors, we also see opportunities. In particular, Asian equities, both in Japan and emerging markets (EMs), look attractive right now relative to other regions.
U.S. Stocks Still Pricey
For the most part, stock and credit markets advanced last week. Encouragingly, the rally in stocks was led by more cyclically sensitive sectors, such as transportation, banks and semiconductors. Credit markets also stabilized, with the spread between the yields of high yield bonds and 10-year U.S. Treasuries now roughly 50 basis points (0.50%) tighter than just a few weeks ago, implying more investor appetite for risk.
Both stocks and bonds are benefiting from relative stability in overseas markets as well as some easing of China fears. Still, volatility remains elevated. Looking at realized returns over the past month, annualized volatility on the S&P 500 Index is above 30%, triple the level from early August. We expect this pattern to continue given the persistence of several factors: a shift in the credit environment, a pending interest rate hike by the Federal Reserve (Fed) and expensive stock valuations.
On the latter, while large-cap U.S. equity multiples are now 7% below their February peak, valuations remain above the long-term average. This is problematic given the pending shift in U.S. monetary policy. Quantitative easing is gone, and while this week’s Fed decision remains a coin flip (will the Fed raise rates or not?), there is no question that U.S. monetary policy is at an inflection point.
Even if the Fed demurs until later in the year, short-term rates are climbing. Last week, two-year Treasury yields traded to just below 0.75%, a high for the year. Without the tailwind of easier money, U.S. equities will need to get by on earnings growth, of which there hasn’t been much of late, rather than monetary policy-induced multiple expansion.