Since the presidential election last fall, the U.S. stock market has enjoyed a rally. The Dow Jones Industrial Average topped 20,000 for the first time ever and the S&P 500, NASDAQ Composite, and Russell 2000 also reached all-time highs in the first quarter. In what may only be described as a well-overdue rally, non-U.S. stocks and bonds, including those in emerging markets, came along for the ride as a rebound in economic growth in China and Europe seems to be materializing despite an unsettled political landscape in much of Germany, and growing U.S. tensions with Russia and North Korea. Investors may finally be waking up to the attractive valuations in non-U.S. markets compared to that of the U.S.
As shown in the graph below, developed market equities (non-U.S.) gained 7.4%, the S&P 500 gained 6.1%, and emerging markets gained 11.5%. Fixed income rose 0.8% while REITs increased 2.5%. After double-digit gains in 2016, commodities took a breather, falling -2.3%.
The U.S. market rally can be summed up as TINA (There Is No Alternative to stocks) meets President Trump. More specifically, stocks are responding to the prospect of pro-growth, pro-business policies that ambitiously seek to create more jobs in the U.S., invest in much-needed infrastructure improvements, reduce government regulation, and lower corporate and individual tax rates. This theme has also been referred to as the “reflation trade,” reflecting the prospects for fiscal stimulus this year.
Speaking of no alternative to low interest rates, one of the most underreported and interesting developments in the first quarter was the surprisingly insignificant attention that the Federal Open Market Committee received when it raised the federal funds rate by 0.25% on March 15.
With the last rate hike, the federal funds rate stands at a modest target rate of 1.0% to 1.25% and potentially 1.50% to 1.75% at year-end. In contrast, the 10-year Treasury bond yields 2.2%, while inflation (measured as the year-over-year change in core CPI) is also running at 2.2%. This means that “real” (10-year Treasury minus inflation) yields are essentially zero, i.e. the Fed’s interest rate policy remains accommodative. To put this in perspective, from 1958 to 2017, “real” yields averaged 2.4%, according to JP Morgan.
The Fed has signaled for more than a year that they intend to gradually increase short-term interest rates (twice in 2017 and three times in 2018) given their outlook for stable economic growth, contained inflation, and low unemployment. Yet, bond yields have remained stable of late with the 10-year Treasury yield nearly 0.40% below its late 2016 high of 2.61%. Despite the prospect that the passage of fiscal policies that will reflate the economy and presumably create additional inflationary pressures, investors finally seem comfortable with a slow and steady rise in interest rates, as a welcome trade-off for GDP growth north of 2%.
The current expansion that started in mid-2007 has become one of the longest expansions on record. The same is true for the duration of the current bull market in stocks. All good things come to an end, and like many, we in early 2016 raised the question “When will it end?”
While we agree that investors should be on the lookout for warning signs of a recession as the recovery ages, the outlook for the economy remains bright at present. Business and consumer confidence has recently registered post-recessionary highs, unemployment rests at a post-recessionary low of 4.7%, and interest rates sit at all-time lows. Equally important to the outlook is that inflation remains benign at just over 2%. Lastly, after several quarters of slowing growth, corporate earnings may continue their recent climb, going even higher, especially if we see reasonable progress in pro-growth policies from Congress.
All things considered, it’s easy to see why stock prices reached new all-time highs recently.
Although difficult to measure, one of the most peculiar characteristics of the eight-year-old bull market is that investors continue to doubt the stock market. We often hear concerns about a bubble in residential housing, commercial real estate, initial public offerings, and the stock market in general. It’s true that stock valuations are above their long-term averages, but investors should not forget that they’ve been rewarded by giving stocks the benefit of the doubt during this recovery.
TINA meets Trump may very well extend the current recovery and the bull market in stocks. But it’s icing on the cake in our view. So long as current fundamentals remain in place and recessionary signs don’t emerge, we believe patient, long-term investors should continue to favor stocks over bonds, especially with real interest rates barely above zero.