In August, bond prices generally moved higher and stock prices were mixed. The broad Barclays Aggregate U.S. Bond Index rose 0.90% last month largely as a flight to safety amid geopolitical uncertainty from North Korean missile testing. U.S. large company stocks in the S&P 500 Index rose 0.31%, but small company stocks in the Russell 2000 Index fell; however, the MSCI Emerging Market Index gained 2.23%. Global economic activity generally continued to expand modestly with solid data coming out of Europe. In the U.S., GDP for Q2 was revised upward to a 3.0% annualized rate, which was better than the median forecast. This strong economic foundation bears emphasizing, because September includes or included a number of events that have the potential to introduce additional uncertainty into financial markets: The U.S. Federal Reserve meets September 19th-20th, the German federal election is on the 24th. We believe that these dates will likely pass benignly, just as two other September items have. As part of hurricane relief, the U.S. federal debt limit was raised to allow repayment of U.S. creditors through approximately December 15th, and funding was provided to keep the government running until December 8th. Both the debt limit and a spending bill must be approved in 3 months. As we explain in this installment of Insights, we think that the divergence between continued economic growth, on the one hand, and low inflation and wage growth, on the other, deserves more scrutiny because it poses questions for U.S. monetary policy and continued expansion.
As noted above, U.S. equity performance was mixed in August, but U.S. large-cap stocks and foreign equities have posted double-digit gains YTD through August.
The S&P 500 Index is up nearly 12% YTD through August, foreign large-cap stocks in the MSCI ACWI ex-US Index are up nearly 19%, and emerging market stocks are up 28%.
Core bond prices were positive during the month. High yield bonds were slightly negative but have gained 6% YTD through August. Emerging market bonds continued to perform very well. This year, the JP Morgan U.S. dollar-denominated emerging market bond index is up nearly 9%, and the local currency emerging market bond index has risen 14.67%.
The global economy, including the U.S., is on strong footing heading into the final four months of the year. Modest growth in the U.S. continues. The 3.0% annualized rate in the second quarter for GDP was a bright spot. We would not be surprised to see a 3Q number less than that, particularly as the effects from Hurricane Harvey (and potentially Irma) weigh on affected regions. Although between 20% to 30% of U.S. oil refining capacity was shut down as a result of Harvey’s devastation along the Texas and Louisiana Gulf Coasts, some of that has begun to come back online. Florida faces more economic disruption before the recovery and reconstruction efforts begin.
Although Irma’s full economic and humanitarian effects remain to be seen, a number of events in September, as noted in the introduction above, are fixed with certainty on the calendar. Germany will hold federal elections on September 24. Over the last year, there had been concerns that a few other European elections might result in nationalist or Euro-skeptic parties taking control of government. That did not occur in places like France, the Netherlands, Spain, or Italy. It also does not appear to be the likely outcome in Germany. Despite some similar worries last year about a potential hardline turn in Germany, the current Chancellor Andrea Merkel of a center-right party leads in current polling, and she is followed by Martin Schulz of the main center-left party. One of these candidates is most likely to win and then form a coalition government. Both candidates would likely endorse policies not too different from those that currently prevail.
In the United States, Congress just passed and the President signed a bill for federal disaster relief in response to Harvey. That package included a provision to raise the U.S. debt ceiling until about December 15th and to allow the government to run until December 8th. Before year-end, Congress will need to revisit the issues. We recall the short-term disruption to financial markets that occurred in the summer of 2013, and we will therefore keep these two government matters on our radar.
When the U.S. Federal Reserve meets September 19-20, it may decide to raise the Federal Funds interest rate again. Chairwoman Yellen has also typically used the two-day meetings to announce other policy decisions because of the press conference that follows. This allows her to explain more fully shifts in monetary direction. Speculation has been high that the Fed will announce a plan to reduce the size of its balance sheet, which ballooned as a result of operations such as the series of quantitative easing programs that characterized the six-year long central bank response to the global financial crisis of 2008. The graph below charts the increase in assets that the Fed owns from approximately $800 billion in 2008 to more than $4.4 trillion today.
However the Fed proceeds with interest rate increases or balance sheet reduction (whether by selling securities or letting them mature without reinvesting the proceeds), we continue to believe that the central bank will be measured, or cautious, in its approach.
A key reason that we believe that the Fed will be measured and thoughtful in its approach to both raising interest rates further and beginning balance sheet normalization is that it faces an economic divergence: economic growth has been consistent and positive, but inflation and wage growth remain low and sluggish. This tension has developed when unemployment has declined to very low levels, and the U.S. economy has returned to former gauges of full employment, a point when both inflation and wage growth typically rise.
This topic deserves scrutiny, in our opinion, because it poses questions for U.S. monetary policymakers and continued expansion. As you can see from the graph to the right, U.S. financial conditions remain looser than average, despite several interest rate increases. This means that it is easier for companies and individuals to secure financing to fund various projects. Easier financing usually leads to greater spending, which typically increases the velocity of money, which in turn has been thought to spur inflation. That has not been the case.
Although the consumer price index (CPI) briefly registered above 2% recently, it has fallen back below the 2% long-term inflation target set by the Fed. It was precisely to combat persistent low inflation and disinflationary forces that the Fed embarked upon its quantitative easing programs. From one perspective, those programs were successful: The U.S. did not fall into a deflationary trap such as has characterized Japan since the late 1980s, and U.S. unemployment has receded significantly since its height during the financial crisis. From another perspective, the programs have not yet been an unqualified success: They have not (yet) returned inflation and the usually accompanying wage growth to normal or long-term healthy levels.
This presents a conundrum for the Fed because of its dual mandate to ensure both full employment and price stability. Easy money conditions have returned the U.S. to full employment, but prices are still running below the long-term target. The employment level and consistent if modest economic expansion justifies normalizing interest rates to higher levels, but raising interest rates may hinder achievement of the Fed’s inflation target. Higher interest rates give the Fed more flexibility to use monetary policy levers in the future to counter economic weakness or recurrence of recession, but higher rates can potentially also choke off the economic growth that will lead to more normal levels of inflation and wage growth.
Another notable development is that major global economies have started to grow in sync for the first time in a decade, as you can see from the nearby chart. This has stemmed in part from the concurrent, if not entirely coordinated, stimulative and low-interest-rate policy in places like the U.S., Japan, and Europe. All 45 countries that the Organization for Economic Cooperation and Development (OECD) covers are poised to grow this year. What is more, 33 of the 45 are set to accelerate the pace of their economic expansion from the rate last year. This degree of economic synchronicity is uncommon.
Whereas the Fed faces a divergence in the U.S. between positive gains in economic growth and employment on the one side and persistently low inflation and stagnant wage growth on the other, there is little divergence between countries in economic expansion.
Positively, stock market returns have this year reflected this synchronized growth. Given the global economic interconnections, this can be a virtuous cycle in which growth in one country spurs growth in another. On the flip side, however, synchronized growth could be problematic if synchronized growth leads to or turns into synchronized contraction. In the past, economic cycles across global participants have differed, and a benefit to this for global trade and financial markets has been that expansion in one country can help to balance recession in another.
We mention this, again, as something that we are watching, not as something about which we are overly worried. Currently, inflation is in aggregate low across most of the OECD, and that allows global central bankers, like their Fed counterparts, to be measured in reducing monetary stimulus. Despite simultaneous growth, some countries are at various stages of their economic cycles. For instance, the U.S. economy bottomed before the major European countries after the global financial crisis, and then it turned cumulatively positive in 2010 before those countries did individually and collectively.
The U.S. economy has been expanding for a longer period of time than the Eurozone as a whole. So, although these countries are all now expanding by various degrees, western Europe is at an earlier phase of its economic cycle than the U.S. Emerging market countries are as a whole also starting to see an uptick in growth that had eluded them the last couple of years.
What does this mean from an investment perspective?
First, although the U.S. will likely see the Fed raise interest rates, the pace will likely be modest, and demand for safe-haven government debt among developed countries will likely keep a lid on U.S. Treasury yields. The U.S. is widely perceived to be, along with Germany and Japan, among the safest government credits; however, as of 9/6/2017, Japanese 10-year bonds are yielding 0.00%, and German bunds are yielding just 0.34%, whereas the 10-year Treasury Note has a yield of 2.10%. Global investors who seek income and relative safety are likely to prefer U.S. government debt to lower-yielding debt elsewhere. For investors, this means that core U.S. bonds, especially agency and corporates, can still provide stability for diversified portfolios, and although there will be some price risk from rising interest rates, yield movements upward (and price movements downward) are likely to be relatively contained.
At the same time, U.S. bonds do not offer a tremendous yield in and of themselves, especially considering that the dividend yield on the S&P 500 Index is itself about 2%, just shy of the yield of the 10-year Treasury. This is in part why investors have flocked to equities in recent years, namely, comparable income and better growth potential. Yet, as we have remarked many times in previous commentary installments, the S&P 500 has posted annualized returns over the last 3- and 5-year periods well in excess of their historical average. Investors should not expect 14% annualized returns over the next 5 years as the S&P 500 Index has returned over the previous 5 years.
This is one reason that we have emphasized the attractiveness of foreign equities, where the dividend yield is currently about 3.5% for developed foreign stocks in the MSCI EAFE Index. Moreover, companies outside of the U.S. have been increasing their earnings levels at a time when earnings in the U.S. are hitting peak levels of this cycle. The chart nearby examines the earnings per share (EPS) across the U.S., Japan, emerging markets countries, and Europe. What you observe is that earnings per share in foreign developed markets and emerging markets have not yet regained their prior cycle highs. If history is a guide, they have more room to run before topping out. This could translate into increased total returns for foreign stocks.
As we noted last month, the economic growth momentum, political stability, and valuation levels of foreign stocks suggest to us that we may be witnessing the beginning phases of a longer-term out performance period for foreign stocks. The same may also be true for emerging market debt, where economic growth is likely to continue in these developing countries, which should further improve economic fundamentals. Despite some additional currency and credit risk in EM debt over comparable maturity bonds from places like the United States, investors are largely being compensated with 300-400 basis points higher income yield to make that investment, a trade-off that we think can make sense for diversified portfolios.
All told, then, although we observe within the September calendar some events that could cause hiccups to financial markets, we think that the deadlines we have noted will come and go without major effect. It is impossible to anticipate geopolitical developments with complete accuracy, such as a potential escalation in the tensions between North Korea and other nations or a diplomatic solution. We are therefore not making tactical portfolio changes in light of the bluster. And for now, despite observing the curious divergence between economic growth and employment gains, on the one hand, and low inflation and weak wage growth, on the other hand, we think that the U.S. economy is on solid footing. It may be slightly further along the growth path than other nations that are also growing, such as Europe and emerging markets, but it shows signs of momentum for additional GDP growth.
Although the potential exists for simultaneous slowdown across economies that are growing in sync at present, that is not our base-case forecast. In fact, in the near-term we think that there will likely be more of the same, a largely steady global growth environment that can benefit growth assets like stocks and certain forms of credit, such as emerging market bonds. Some of these assets have posted sharply positive gains year-to-date, and we would not be surprised to see a temporary pullback. Whether that occurs, we observe signs now that the investment environment through the end of 2017 should be mostly stable and even supportive for the assets that typically make up our diversified portfolios. As always, we respect the trust you have placed in us, and we welcome any questions you may have about our views on the current economic and market environment.
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