Insights / 11.01.2017
Global equity markets finished up for the 11th straight month, as markets continue to gain confidence in the breadth and sustainability of the global economic recovery. In the U.S., the S&P 500 index ended October at an all-time high on a string of positive economic news, including a second straight quarter of 3% annualized GDP growth, rising wages, and robust consumer confidence. The following table contains a summary of October’s market performance:
|S&P 500 (Total Return)||+2.33%||+16.91%||All Country World Index (Net)||+2.08%||+19.69%|
|MSCI EAFE (Net)||+1.52%||+21.78%||Barclays Aggregate||+0.06%||+3.20%|
|MSCI Emerging Markets (Net)||+3.51%||+32.26%||60/40 Blend*||+1.28%||+13.41%|
* 60% All Country World Index/40% Barclays Aggregate
Third quarter U.S. GDP growth was 3%, but the number was supported by an unexpected build-up of inventories and a bump in auto sales as drivers replaced cars destroyed during the hurricane season (car sales are estimated to be 200,000 to 500,000 a month higher). In the absence of those two factors, GDP grew 2.4%, a rate still thought to be above the economy’s trend growth rate. An index of manufacturing fell from its September high of 60.8, but any value above 50 describes a manufacturing sector that is growing.
U.S. labor markets continue to tighten. Initial unemployment claims fell to a 44-year low. Hiring is strong across sectors including construction as firms ramp up to replace the hurricane damaged housing stock. In 2009, the U.S. had 6.4 out-of-work Americans per job-opening. Today, there are 1.2 out-of-work Americans per job opening. That tightness is reflected in worker optimism. Over 35% of workers say jobs are plentiful, the highest since the financial crisis, and the percentage anticipating a raise in the next six months is back to pre-recession levels. In October, wages were 2.9% higher than a year earlier, while the employment cost index rose 0.7% month-over-month, a sign of accelerating labor costs. Confidence in their job and wage prospects contributed to consumer confidence reaching a 17-year high.
The strength in equity prices reflects investor confidence in the sustainability of the goldilocks economy and its implications for corporate earnings. Third quarter S&P 500 earnings are expected to grow by 4.9%. The hurricanes have had a significant impact on earnings. Insurance sector earnings are down 60%. Excluding the insurance sector raises S&P 500 earnings growth to 7.6% for the quarter. Looking forward, management has guided above consensus earnings 1.4x as much as below. Despite its gains, strong earnings growth for S&P 500 companies has left valuations largely unchanged. The S&P 500 index P/E ratio started the quarter at 17.8 and is now 17.9. As investors weigh improving fundamentals against valuations, market sentiment is mixed. One measure shows managers overweight global equities while another measure shows fund manager cash levels above their 10-year average. Bullish sentiment increased to 63% from a 2017 low of 47%. At the same time U.S. equity mutual funds and ETFs experienced a net $36 billion outflow.
Bonds markets showed little reaction to reports that the next Fed chairperson would be current Fed Governor Jay Powell. Most likely because he has been a supporter of Janet Yellen’s approach to normalization. While the announcement had little impact, other central bank announcements suggest rising interest rates in the year ahead. Language coming out of the Fed’s most recent meeting upgraded the nation’s growth rate from “moderate” to “solid” supported by “moderate” household spending and a pickup in business capital spending. Those remarks were enough for the market to now believe the Fed will raise the Federal Funds rates one more time in 2017 and likely three times in 2018.
With realized and expected inflation remaining under 2%, the 10-year U.S. Treasury Bond yield was largely unchanged during the month, finishing at 2.35%. Looking out to 2018, however, the combination of Fed tightening, the unwinding of its $4.5 trillion balance sheet and thus a reduction in Fed demand for treasury, and mortgage backed assets, along with sustained wage and economic growth suggests a rise in longer duration interest rates. Upward pressure on U.S. rates will also come from a reduction in European demand for higher-yielding U.S. bonds.
Elsewhere in the world, investors are observing accelerating growth in output and earnings, supporting higher equity prices. In Europe, third quarter GDP estimates beat expectations and the unemployment rate fell more than anticipated. This led measures of business and consumer confidence to reach near all-time highs. Inflation, at less than 1.5% continues to be lower than desired. In response, ECB head Mario Draghi warned that the central bank will remain cautious even as it begins to wind down its bonds purchases, a statement supportive of sustained growth.
The Japanese economy continues to improve. Unemployment fell to 2.8%, its lowest level since 1994. While the U.S. has more job seekers than jobs, Japan has more jobs than applicants; its job-offers-to-applicant ratio is 1.52. With labor markets continuing to tighten, income rose 3% year-over-year.
In the emerging markets, Chinese manufacturing fell from 52.4 to 51.6, but is still expanding. The decline reflects new government-mandated curbs on polluting firms that forced Chinese steel companies to cut output ahead of the winter. The new rules also reinforce the view that Chinese growth will continue to slow over time as the economy attempts to move away from government-supported, export-oriented industries to consumer-led growth, which is less reliant on leverage to sustain growth. Chinese equity markets largely shrugged off the new rules and fall in output.
Though evidence points to a continuation of steady growth, low inflation and improving earnings across the globe, markets are not without risk. While current asset valuations make many investors nervous, historically high valuations are an indicator of lower future returns and are not the source of a selloff. Instead risk will increase as central banks begin to wind down their quantitative easing programs. Investors (1) should expect real interest rates to finally move from near zero to values reflecting real growth; and (2) for market volatility (currently at record lows) to return to more normal levels. In a healthy economy, market volatility reflects investors choosing good investments over bad. If a market is characterized by visible or unseen asset price bubbles, rising volatility can lead to market sell-offs even in a growing economy.
Caprock’s Investment Committee continues to recommend maintaining target allocations to U.S. equities due to expectations of positive economic and earnings growth through 2018. However, we also recognize risks exist. 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.