This Bull Is Old, But Not Sick…
Jerry Chafkin, Chief Investment Officer
- Despite being very late in the current market cycle, we are not yet observing the excesses that would signal the imminent demise of the rally in US stocks.
- Rising interest rates and on-going trade friction support a resurgent US dollar which will likely depress international equity returns for the remainder of the year.
- We believe that concerns about debt levels miss the point that the drag on profitability is not debt itself, but the cost of servicing that debt which - thanks to low interest rates - will not become burdensome in the near-term.
- It is unclear at this time whether the aggressive US stance on trade policy is aimed at eliminating trade deficits, or just a negotiating tactic aimed at more balanced trade agreements. It may not matter in the near-term as businesses need to make planning decisions, and the uncertainty surrounding the impact of potential tariffs weighs on the market.
- We remain optimistic that over the next twelve months US stocks will do well given a monetary policy that is accommodative to neutral, tax cuts and increased federal spending. However, it would be naïve not to anticipate a downturn sometime thereafter, as monetary policy tightens and earnings slow. For this reason, we think prudent investors are best served by well-diversified portfolios including some international equity exposure as well as “hedges” such as fixed income, managed futures and tactical de-risking strategies.
The current rally in the US stock market is now in its 9th year and appears to be on track to become the longest in history. Since its official start on March 9, 2009, the current US stock rally has returned a whopping 302%1 from the market’s low at the end of the Great Financial Crisis. Since then it has grown, uninterrupted by a decline of 20% or more (i.e., the definition of a bear market). The prospect of breaking the longevity record is a double-edged sword for investors who are grateful for the rewards provided, but anxious about what they can look forward to in such an old rally. This anxiety may be especially acute today with global equity markets having returned -0.8% for the first half of 2018, when for the same period last year, they had already returned +11.8%2. Investors may be fretting about this geriatric market, assuming death is near and debating whether the cause of death will be rising interest rates, excessive valuations or trade policy. But market returns are not earned evenly over time and any debate over the cause of death seems highly premature given the economy doesn’t currently seem to be suffering from any of these illnesses. Like people, market rallies don’t die because they’re old, they die when an illness becomes acute.
Valuations seem defensible
While there is no question this rally is old, it seems in surprisingly good health. Economic growth appears to be strong (NY Fed and Atlanta Fed forecasting 2.8% and 3.8%, respectively for Q2), corporate earnings continue to grow and even though interest rates have been rising, credit availability is still easy.
Bear markets do not come out of nowhere. They are associated with recessions that generally come with warning signs like declines in manufacturing and housing, and increases in jobless claims. At the moment, business sentiment, new home sales and unemployment claims all seem to be trending in a positive direction, with healthy spending by consumers and capital expenditures by business.
The longevity of the current economic expansion may be explained by its slow rate of growth relative to other periods of economic expansion. More importantly, tax cuts, increased federal spending and a monetary policy that is still accommodative are like Viagra for an old market, which means this rally will not necessarily act its age. Recognizing this, we should expect the drugs to wear off at some point in 2019.
While it is true that current valuations as measured by the ratio of price to forward earnings estimates (i.e., the P/E multiple) are relatively high from an historical perspective, they are below recent highs and earnings reports keep providing positive surprises. We’ve pointed out before that appropriate P/E multiples are in many ways a function of the level of interest rates. This is true from both a relative value perspective, comparing the earnings yield of stocks to that on the 10-year US Treasury, as well as from a balance sheet leverage perspective facilitating higher earnings with the help of inexpensive debt. In addition, a recurring dynamic that has helped to support and advance stock prices throughout this rally are share buy-backs by corporations. Buy-back activity was again unusually strong this past quarter.
Debt Levels in Perspective
Not everyone views these share buy-backs as benign. Skeptics would argue that the US economy is currently awash with record levels of government, corporate and household debt. They attribute the record level of corporate debt to corporations using cheap debt to take cash from their balance sheets to send it to shareholders in the form of dividends and stock buy-backs. They view this behavior as a new version of financial engineering that converts equity into debt and sacrifices futures growth for present consumption by diverting capital from productive long-term investments to inflate a bubble in corporate stocks that will eventually burst when interest rates rise, plunging the economy into recession3.
It is easy to understand how this portrayal of current debt levels would make investors anxious. The fact that corporations in aggregate are more indebted than ever sounds bad, right? But because interest rates have been so low, the interest expense to support this debt is relatively low. Corporate earnings today are roughly 7-times interest expense and are not materially different today than in 1993 or 2003 - which were both early in prior expansion cycles - and delinquencies on corporate debt are lower than earlier periods4.
“Okay,” you might say, “but what happens when interest rates start to rise? Won’t companies quickly find interest costs becoming an increasing burden?” While it is believed that at least one-third of stock buy-backs have been financed with borrowed money, it is not clear that such debt is floating-rate/short-term. In fact, the majority of buy-backs appear to be financed with cash from earnings sitting on corporate balance sheets5. Given that capital expenditures are strong, investment is hardly being starved. While it may be disappointing that returning capital to shareholders is currently the best use of capital, maximizing shareholder wealth is what management gets paid to do.
Perhaps more important to extending the current economic expansion than corporate debt is household debt, since household consumption makes up 70% of gross domestic product. The good news here is that household debt per capita is at the same level today as it was 14 years ago6. In fact, household debt relative to net worth is actually declining, which is unusual for an expansion, and may explain why the growth rate of the expansion has been relatively slow.
Low debt levels and low delinquencies for households are most common in the early stages of an expansion and may, therefore, be a tailwind for the economy rather than an impending risk.
Inflation appears to be on the rise. Input price indices are all up. The Fed’s preferred measure of inflation (which excludes energy and food) finally hit its 2% target for the first time in almost 6 years, and rising prices here and abroad have central banks either in tightening mode (U.S.) or non-easing mode (Europe)7.
Even if the stock market rally is not sick at the moment, it will eventually come under pressure, if and when monetary policy become restrictive (e.g., in excess of 3.25%), or if and when the US dollar’s strength begins to hurt US exports. The Fed’s overnight rate is currently at 1.91%8. At this level, even if the Fed announced a 25 basis point rate hike each quarter for the next four quarters, interest rates would basically still be at a neutral (neither restrictive nor accommodative) level.
Having said this, the pace of the rise in rates is not pre-ordained. The Fed has made clear that it will be guided by the data, and while the numbers currently appear to be able to support and even warrant higher rates, Fed forecasts of quarterly growth vary over time and among the regional Federal Reserve banks. As a result, future rate hikes are not fully reflected in current market prices. A September increase appears to be fully reflected in current prices, but the possibility of an additional December increase is only 50% reflected.
At this point in time when the Fed increases rates, it is both positive and negative for stock investors. On the one hand, it signals that the Fed feels the economy is growing strongly enough to warrant higher rates. On the other hand, it brings monetary policy one step closer to being restrictive. And while it’s possible that the Fed finds the perfect pace of rate hikes to control growth without stopping it, the Fed does not have a promising track record of tightening without triggering a recession.
Tariffs and Trade Policy
Given the positive earnings surprises and stock buy-back announcements from corporations, it would be fair to wonder why the market results have not been stronger for 2018. One answer may be that the focus of analysts and investors recently has been on trade policy and the potential impact of President Trump’s announced tariffs on the global economy. While I am no fan of Trump’s brinksmanship regarding trade for reasons I’ll explain in a moment, I think it’s important that investors keep in mind that this is a rally that has survived the Brexit vote, a series of eurozone crises, and worries about nuclear war and kept on chugging so long as corporate earnings were growing and monetary policy was accommodative. Up until recently, the market had discounted the President’s tariff and trade pronouncements as a strategy to renegotiate various treaties, and believed that it would not be allowed to get out of hand since it was understood that an outright trade war would hurt all parties. And indeed, we have been lucky to date that the tariffs announced or imposed by our trading partners in response to US tariffs have been reassuringly measured, rather than escalating the threat.
The President’s current tariff policy makes no sense to most economists, which is part of why the market had dismissed it as a negotiating tactic. This may well be the case, but that doesn’t mean that it won’t hurt our economy. Companies need to plan, and the long lead times required to shift or reduce production to hedge the impact of tariffs mean decisions need to be made sooner rather than later.
Because President Trump’s goal may be to bring manufacturing jobs back to the U.S., his focus seems to be on reducing our trade deficit with our largest trading partners, rather than trying to neutralize tariffs or to ensure fair trade. This strategy can have consequences well beyond manufacturing jobs, since countries like China that have a large trade surplus with the U.S. offset this through direct investment in the U.S. and loans (i.e., buying our debt) to finance our trade and budget deficits.
China is our largest trading partner and holds 7% of U.S. Treasury debt. Other foreign countries hold an additional 30% of U.S. Treasury debt. Given U.S. reliance on debt to finance our spending, alienating the purchasers of that debt at the same time that the U.S. is increasing issuance, raising interest rates and reducing the amount held by the Fed seems extremely risky given the potential for harm to US exports and upward pressure on interest rates.
Market Outlook and Portfolio Positioning
Stocks over Bonds: We think the environment is likely to favor stocks over bonds for the next six to twelve months. This view stems from our belief that earnings will continue to grow, even if earnings rate starts to slow; and that rising interest rates will hurt bonds, even though it will take some time before these interest rate increases begin to restrict growth. Our preference for stocks is relative, however, and does not imply we expect them to deliver an above-average return for the full year.
Although US equity returns for the first half of 2018 have been lackluster, this is not atypical for US stock market returns in a mid-term election year and is usually followed by a bounce toward year-end after the elections. Beyond continued strength for the global economic expansion and equity markets over the next 12 months, we believe some sectors are better positioned than others to benefit in this current phase of the market cycle.
Small-cap stocks were due to rally having underperformed large-cap stocks over the last several years. As a result, their outperformance of almost 4.5% relative to US large caps in the second quarter served to simply bring their trailing 3-year return in line with those for large-cap stocks. On the other hand, fear of escalating tensions between the U.S. and its trading partners may have led investors to favor the stocks of companies that are less dependent on sales outside the U.S. (often smaller companies). If this was indeed the market’s rationale, small-cap stocks may continue to outperform so long as trade tensions persist.
High Yield Over Investment Grade Bonds: While we are generally cautious regarding interest rate risk and the outlook for bonds (it’s not clear that two more rate hikes this year are fully reflected in current prices), the typically shorter duration and participation in earnings growth of high-yield bonds should make them less vulnerable than higher grade debt to continuing rate hikes in the U.S.
U.S. vs International: The relative strength of the US economy, the tone of news around trade policy, the role of rising rates in strengthening the US dollar and political challenges in Europe will be headwinds for US investors holding international assets in the near term. Timing the “turn” in the Foreign Exchange markets is always difficult and the respectable returns in local currency terms for international stocks and their relatively attractive valuations suggests that investors should always hold some international equities, but that they are unlikely to best US equity returns in the next six to twelve months.
Prepare for the Unexpected: Given the potential for change in inflationary expectations, global trade policies, the pacing of interest rate hikes and the rate of growth in corporate earnings, it behooves investors now - as ever - to diversify and to hold some core fixed income, bond alternatives, managed futures and tactical limit-loss strategies in addition to their core equity allocation.
1 Source: Barron’s 6/30/2018
2 Source: Morningstar
3 Source: Washington Post, “Beware the ‘Mother of all Credit Bubbles’”, 6/8/2018
4 Source: Advisor Perspectives, “Time not to Freak Out About Debt Again”, 6/12/2018
5 Source: CNBC, 7/02/2018
6 Source: Advisor Perspectives, “Time not to Freak Out About Debt Again”, 6/12/2018
7 Source: CNBC, 6/29/2018
8 Source: Bloomberg 7/03/2018
Asset Class Index Description
US Equities S&P 500 A cap-weighted index that is generally considered representative of the US equity market, consisting of 500 leading companies in leading industries of the U.S. Market capitalizations are generally above $5 billion representing approximately 80% of available market capitalization.
US Small Cap Russell 2000 An unmanaged index consisting of those companies considered to represent the small-cap segment of the US equity market. It is a subset of the Russell 3000 Index based on market capitalization.
International Developed Equity MSCI EAFE A free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of countries considered to represent developed markets, excluding the U.S. and Canada.
Emerging Markets Equity MSCI Emerging Markets A free float-adjusted market capitalization index that is designed to measure the equity market performance of countries considered to represent emerging markets.
US Fixed Income Bloomberg Barclays US Aggregate The index covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS sectors. U.S. Agency Hybrid Adjustable Rate Mortgage (ARM) securities were added to the U.S. Aggregate Index on April 1, 2007.
US High Yield Bloomberg Barclays US Corporate High Yield The index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes emerging market debt.
US Investment Grade Credit Bloomberg Barclays US Corporate The index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements.
US Short Treasuries Bloomberg Barclays US Treasury 1-3 Year The index measures the performance of short term government bonds issued by the US Treasury. It includes all publicly issued, US Treasury securities that have a remaining maturity of between 1 and 3 years, are non-convertible, are denominated in US dollars, are rated investment grade, are fixed rate, and have $250 million or more of outstanding face value.
US Long Treasuries Bloomberg Barclays US Treasury Long The index measures the performance of long term government bonds issued by the US Treasury. It includes all publicly issued, US Treasury securities that have a remaining maturity of 10 or more years, are non-convertible, are denominated in US dollars, are rated investment grade, are fixed rate, and have $250 million or more of outstanding face value.
International Fixed Income Bloomberg Barclays Global Aggregate ex US The index is a measure of global investment grade debt from twenty-three local currency markets. This multi-currency benchmark includes government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. The index also includes Eurodollar, Euro-Yen, and 144A Index-eligible securities, and debt from five local currency markets not tracked by the regional aggregate benchmarks (CLP, MXN, ZAR, ILS and TRY).
US Real Estate Dow Jones US Select REIT Index A broad measure of the performance of publicly traded US real estate securities, such as Real Estate Investment Trusts (REITs) and REIT-like securities.
BRIC MSCI BRIC Index (USD) The MSCI BRIC Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance across the following 4 Emerging Markets country indexes: Brazil, Russia, India and China. With 307 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Brazil MSCI BRAZIL Index (USD) The MSCI Brazil Index is designed to measure the performance of the large and mid-cap segments of the Brazilian market. With 53 constituents, the index covers about 85% of the Brazilian equity universe.
This report is for informational purposes only, and is not a solicitation, and should not be considered investment advice. The information in this report has been drawn from sources AssetMark believes to be reliable, but its accuracy is not guaranteed, and is subject to change. Investors seeking more information should contact their financial advisor. Financial advisors may seek more information by contacting AssetMark at 800-664-5345.
Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. It is not possible to invest directly in an index.
Investments in mutual funds and exchange traded funds that hold equities, bonds, and other securities can decline significantly in response to adverse market conditions, company-specific events, changes in exchange rates, and domestic, international, economic, and political developments. Investments in bonds and fixed income related securities also involve market and interest rate risk (prices can decline, if interest rates increase), and default risk (an issuer being unable to repay principal and interest). High-yield bonds are generally subject to greater risk of default and volatility, than investment-grade bonds. Real estate investments are subject to credit and market risks, typically based on changes in interest rates and varied economic conditions. Investing in alternative investments, including managed futures, commodities, and currencies is not appropriate for all persons, as the risk of loss is substantial. Investments in futures involve market, counterparty, leverage, liquidity, interest rate, foreign currency, commodity, volatility, and other risks.
For more complete information about the various investment solutions available, including the investment objectives, risks and fees, please refer to the Disclosure Brochure and applicable Fund Prospectus. Please read them carefully before investing. For a copy, please visit www.assetmark.com, or contact your AssetMark Consultant or Financial Advisor.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
AssetMark, Inc. is an investment adviser registered with the Securities and Exchange Commission. Jason Thomas is also Chief Executive Officer & Chief Investment Officer of Savos Investments, a division of AssetMark, Inc.
©2018 AssetMark, Inc. All rights reserved.
For general public use.