Insights / 09.01.2017
Despite continued strong economic and earnings outlooks as well as additional clarity on tax reform, U.S. bonds outperformed U.S. equities in August. Treasury bonds rallied, causing the U.S. 10-year Treasury bond yield to fall to a post-election low of 2.1%, as many investors sought safety against the risks of conflict with North Korea, the possibility that Congress will fail to raise the debt-ceiling limit next month and the economic implications of Hurricane Harvey. The S&P 500 registered its smallest increase since March, but still posted positive returns for the ninth time in the last ten months. Emerging market equities continue to outperform the developed markets as investors recognize the implications for earnings from improving growth. The following table contains a summary of August’s market performance:
|S&P 500 (Total Return)||+0.31%||+11.93%||All Country World Index (Net)||+0.38%||+15.03%|
|MSCI EAFE (Net)||-0.04%||+17.05%||Barclays Aggregate||+0.90%||+3.64%|
|MSCI Emerging Markets (Net)||+2.23%||+28.29%||60/40 Blend*||+0.62%||+10.74%|
* 60% All Country World Index/40% Barclays Aggregate
After closing at a record high on August 7th, the S&P 500 dropped 1.4% just days later, its biggest one-day sell-off in three months. This was the biggest sell-off in three months following President Trump’s forceful response to a North Korean missile test. The CBOE Volatility Index (VIX), a measure of expected near-term stock market volatility, closed at its highest level since the election. As tensions eased, the S&P 500 remained range bound before rallying over 1% in the final week to end the month up slightly.
At 17.5X forward earnings, the S&P 500 is trading above its 5-year average P/E ratio. These modestly elevated valuations have been further underpinned by a string of positive U.S. economic news in August. Second quarter GDP growth was revised upwards from the 2.6% reported last month to 3.0% (on an annualized basis) on stronger than originally thought consumer spending and business investment. U.S. factory output grew at its fastest pace in six years. An index measuring the backlog in orders matched its high for the last three years, a leading indicator for production and labor demand in the quarter ahead. While overall employment growth in August was below expectations, manufacturing employment increased the most in five years, and construction jobs rose by 28,000, the most since February. Average hourly earnings rose 0.1% month-over-month, for a 2.5% gain year-over-year. Corporate earnings were better than expected in the second quarter. While forecast to grow 6.4%, S&P 500 earnings ended the second quarter 10.7% higher as 73% of companies reported earnings surprises and 70% reported better than expected sales growth.
The annual gathering of global central bank leaders in Jackson Hole in late August produced no unexpected news regarding monetary policy and interest rates. Fed Chair Janet Yellen concluded that the financial system is safer today than it was before the financial market crisis. She also stated that the risks of “excessive optimism” and leverage “may require policy responses.” Her comments led some analysts to conclude that the Fed believes keeping rates too low for too long encourages risk taking it does not want to promote, opening the door for a December rate hike if conditions warrant it. ECB head Mario Draghi reiterated comments he made earlier in the summer that “a significant degree of monetary accommodation” is still warranted until wages and inflation accelerate.
Elsewhere in the world, it was noted that for the first time since 2007, all 45 countries tracked by the OECD are poised to grow in 2017, with 33 of them set to grow faster than in 2016. Credit for the global expansion was given to the fading effects of the financial crisis, the reversal of the 2014-2015 commodity bust, continued easy monetary policy and rising domestic demand in the developing markets. Emerging market equities have benefitted from the global recovery, and are up over 28% year-to-date. Despite their strong performance, emerging market stocks sell for 12.6X forward earnings, just above their historical average, and at a 30% discount to developed market equities. Earnings growth for emerging market equities is forecast at nearly 16% for 2017, and historically emerging market returns have closely tracked earnings growth. Performance has been led by technology stocks whose earnings are forecast to grow by 32% for the year.
The Caprock Investment Committee continues to assign a high probability to positive economic and earnings growth through 2018 as the basis for maintaining a target allocation to U.S. equities. However, we also recognize that the market’s strong performance could raise the possibility of profit taking and a market draw down. As a result, portfolios that are overweight U.S. equities should continue rebalancing to their strategic allocation.
This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but Caprock makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.