Weekly Commentary Overview
- U.S. stocks were essentially flat in a holiday-shortened week, while long-term bond yields slipped.
- Both stocks and bonds are feeling the brunt of mixed economic data, which has inhibited earnings gains for stocks and is also one of the factors keeping long-term yields contained.
- The latter is somewhat surprising given the growing likelihood that the Federal Reserve (Fed) will start to nudge short-term rates higher in December.
- We believe long-term yields are likely to remain low for some time, and within our bond portfolio prefer Treasury Inflation Protected Securities (TIPS).
- These offer some hedge against what we view as unrealistically low inflation expectations.
Stocks Show Little Movement
U.S. stocks were essentially flat in a holiday-shortened week, while long-term bond yields slipped. The tech-heavy Nasdaq Composite Index fared the best, gaining 0.45% to close the week at 5,127, while the S&P 500 Index inched up 0.04% to 2,090 and the Dow Jones Industrial Average slipped 0.14% to 17,798. Meanwhile, the yield on the 10-year Treasury fell from 2.26% to 2.22%, as its price rose.
Both stocks and bonds are feeling the brunt of mixed economic data, which has inhibited earnings gains for stocks and is also one of the factors keeping long-term yields contained. The latter is somewhat surprising given the growing likelihood that the Federal Reserve (Fed) will start to nudge short-term rates higher in December. We believe long-term yields are likely to remain low for some time, and within our bond portfolio prefer Treasury Inflation Protected Securities (TIPS). These offer some hedge against what we view as unrealistically low inflation expectations.
Third-Quarter Earnings Report Card Is In
With the third-quarter earnings season coming to an end, it is now clear that company earnings are not strong enough to push stocks substantially higher. Quarterly earnings growth was down 3.3% year-over-year, while revenue growth contracted by 4.4%. Part of the problem: After years of levitating at record-high levels, profit margins are coming under pressure.
Still, stocks have managed to climb back in recent weeks to within a few percentage points of their all-time high thanks to multiple expansion (in other words, investors willing to pay more per dollar of earnings). At nearly 19 times trailing earnings, the S&P 500 is now trading in the top decile of its 10-year valuation range. But despite support from multiple expansion, this year has not provided the necessary earnings growth to propel stocks meaningfully higher.
More Volatility and Gains in Unexpected Places
Meanwhile, volatile stock markets outside the U.S., namely in emerging markets (EMs), offer little solace for weary investors. Last Friday, Chinese A-Shares were down 5.5%, their biggest loss since late August. Chinese equities are likely to remain volatile given decelerating economic growth, falling profits — emphasized again last week with a sharp drop in industrial profits — and more evidence of firms struggling under heavy debt burdens.
But there has been at least one surprising winner among emerging markets: Argentina. Stocks in the South American nation, long a pariah for international investors, have surged year-to-date. The stock market is up over 50% in local terms, which translates to 35% in dollar terms. Argentine stocks were further supported last week on optimism over the election victory of opposition candidate, Maurico Macri.
No, we do not envision a significant surge in inflation. But we do think inflation expectations may be too sanguine. As such, we would prefer TIPS to plain-vanilla Treasuries in our bond portfolio.
Long-Term Yields Still Remain Anchored: Favor TIPS
In fixed income markets, the story in the U.S. is eerily similar to equities in that bonds, although volatile, have not moved much this year. Ten-year U.S. Treasury yields are within five basis points (0.05%) of where they started the year, thanks in part to the muted nature of the economic recovery.
For example, third-quarter gross domestic product was revised higher last week, as expected, but the gains came from a slower pace of inventory liquidation. More recent data confirm the generally solid, but still mixed, state of the economy. Durable goods orders were well ahead of expectations, but consumers remain cautious despite recent wage gains. Consumer confidence slipped and consumer spending is not accelerating. Finally, one of the better leading indicators, the Chicago Fed National Activity Index, remains stuck close to zero, suggesting growth of around 2.50% for the first quarter of 2016.
With the economy unable to break above this threshold for any length of time, our base case scenario calls for an only modest rise in long-term yields in 2016. Moreover, several factors unrelated to economic growth should keep rates from rising above the 3% threshold: an aging population, a dearth of supply of bonds and persistent institutional demand for fixed income instruments. All of these either increase demand or reduce supply, which supports prices and, therefore, keeps yields low.
What could change that scenario? Two potential catalysts: a much more dramatic acceleration in the global economy, which at this point seems difficult to imagine, or more likely, some firming in inflation expectations.
Indeed, we would expect some stabilization in inflation and inflation expectations given declining slack in the labor market, structural inefficiencies and ambiguous productivity gains. Also, U.S. inflation should firm as the one-off impact of a stronger dollar and lower energy prices start to fade from the Consumer Price Index calculations.
No, we do not envision a significant surge in inflation. But we do think inflation expectations may be too sanguine. As such, we prefer TIPS to plain-vanilla Treasuries in our bond portfolio.