Published on Feb. 13, 2018
Strong Start to the New Year
Stocks began the year with considerable strength, as the S&P 500 returned 5.7% for January. Investors appeared to key in on robust global growth and healthy US corporate profits. While we are keeping a close eye on interest rates, we maintain our constructive stance on the market, as we continue to expect that the combination of strong fundamentals and still easy financial conditions should bode well for stock prices.
The steep increase in Treasury yields has been one of the key capital market developments to begin the year, as the 10- year US Treasury bond recently yielded about 2.8%, up from just 2.4% at the end of December. We think that much of this move has been a reflection of healthy economic conditions, both domestically and abroad. Moreover, the recent rise notwithstanding, yields are still low by historical standards and in our view are not approaching levels which would materially derail economic activity.
However, while the absolute level of interest rates remains subdued, the velocity of the ascent has been disconcerting for investors. If yields continue to climb rapidly, we would expect it to cause perturbations throughout capital markets. With valuations somewhat stretched, equities would likely be vulnerable to a pullback, as for some time now investors have been able to justify higher P/E ratios at least in part due to the low interest rate environment. In summation, a 10-year Treasury yield of less than 3% need not be a headwind for stocks in and of itself. However, a 40 basis point move in one month is a great deal of volatility for the Treasury market, and therefore we will continue to closely monitor it as a source of risk for equities moving forward.
The dollar, which recently fell to a multi-year low, has also been in focus for investors. We view this drop as being favorable for equities, as a weaker dollar typically boosts exports and enhances the profits of US based multinationals. We think that a key factor behind the decline has been healthy international economic growth. Momentum in major foreign economies has led investors to speculate that central banks will speed up their monetary policy normalization, boosting their currencies in the process. We do think there is a threshold after which further dollar declines become counterproductive for stocks. For now though, particularly with inflation remaining low by historical standards, we continue to view the dollar’s weakness as being supportive for stocks.
Fourth quarter earnings season is well underway, and thus far the results have been quite encouraging. With just over 40% of the S&P 500 having reported, aggregate profits are up a healthy 12% – well ahead of expectations for 9% growth – and 81% of companies are exceeding earnings estimates, the highest level in 7 years. Moreover, a record 75% of companies have raised guidance for the year, and while some of this has likely been a function of the recent tax legislation, we think that strong fundamentals are playing a role as well.
We maintain our positive stance on the market, as both fundamental and financial conditions remain supportive, in our view. Global economic growth has been robust and the IMF recently raised its growth estimates for both this year and next year to 3.9%, which would be the best performance since 2011. It is not just the magnitude but the breadth of the growth which has been impressive. Furthermore, 2017 marked the broadest synchronized growth since 2010, as 120 countries representing 75% of global GDP saw higher year-over-year levels of business activity.
While many investors are beginning to anticipate tighter global monetary policies, particularly in Europe and Japan, we continue to view financial conditions in aggregate as being supportive of equities. Market indicators such as corporate bond spreads and the aforementioned weak dollar do not suggest tight conditions. As well, even with certain central banks seemingly poised to pick up the pace of their policy normalization plans, we note that projections for the aggregate balance sheet of the Federal Reserve, ECB, BOJ, and BOE is to be little changed from current levels over the next few years.
As noted, we view any further spikes in treasury yields as the key risk factor for equities currently. Elsewhere, we are concerned about certain pockets of the US economy. Housing, for example, is particularly vulnerable to a higher yield environment as affordability drops with increasing mortgage rates. The industry may also experience some headwinds pertaining to the recently enacted tax legislation, which limits deductions on mortgage interest expense. While we have little exposure to this space in the portfolio at this time, we will continue to monitor these risk factors as they develop.