02 Dec 2016 What Are Stocks and Bonds Telling Us?
We are getting a lot of questions about things like the ‘Trump Rally,’ inflation, and owning bonds in the face of rising interest rates. These are all reasonable concerns given all the changes being openly discussed by the new administration and congressional policy makers. But aside from an unexpected and unprecedented victory like Mr. Trump’s, markets, economists, and policy makers are reacting pretty much as they should.
Mr. Trump has announced his intentions, with both parties in Congress largely in agreement, that massive federal spending is needed to modernize this country’s neglected infrastructure; specifically that of pipelines, roads, rails and airports. Significant increases are also coming for the military. Stocks naturally rise on news like this, particularly those of industries directly impacted. Big government spending on infrastructure suggests a healthy rise in blue collar and middle class employment and wages. When security rises, consumer spending rises as a result, so an even broader swath of stocks enjoy price increases.
Some express concern over the already high prices of stocks. New rallies push valuations ever higher setting them up for a fall they say. But that’s only one potential outcome of over-priced stocks, if indeed they are over-priced. The more likely possibility, given the pro-business policy environment shaping up in Washington, is that corporate earnings will rise faster than expected to justify higher stock prices of today. Stock investors set prices on stocks by anticipating future earnings prospects.
One way to measure stocks’ valuation is by tracking the price/earnings (or P/E) ratio on future earnings, known as the forward P/E Ratio. The current S&P 500 P/E Ratio Forward Estimate is at a current level of 17.9, down from 18.55 last quarter and down from 22.10 one year ago. While the current ratio is considerably higher than the 10-year average of 14.6 (according to Factset) it is worth noting that the US economy has experienced sub-par economic growth for the past decade, due to multiple wars and a lengthy Great Recession. Stocks may well be correctly anticipating a new period of American economic and corporate growth this time because of new and powerful incentives being promised.
Bond investors are in agreement with stock investors on the brighter outlook for the American economy. The WSJ reports that the yield on the 10-year US Treasury note rose to a 17-month high, at 2.444%, up from 2.365% Wednesday. The surge since July has pushed the 10-year yield up by more than 1%, only the fourth time it has risen so much so fast since 2009.
Today’s labor report provided further good news for the economy as employers continue to hire at a steady clip and the unemployment rate fell to 4.6% from 4.9% in October, the lowest level in nine years. But still, the numbers of workers who do not participate in the workforce remains near all-time highs. The good news from this statistic though is that as the economy reaches what economists call full-employment, there remains, at least in theory, a reserve of new workers waiting to re-enter the job market when prospects improve. The extra supply of workers helps keep a lid on wage-price pressures, a key driver of inflation in the US economy.
So far the theory is proven true as the improvement in the economy and hiring has not sparked any significant increases in inflation. It’s the uncertainty of what lies ahead, with the potential of tax cuts and government spending that if not offset by cutbacks in other areas, will be inflationary. Left unaddressed for a few years, there’s the worry that continued annual government deficits of a half-trillion added to the historically high $20 trillion in government debt, will drive inflation higher as the government struggles to meet the interest costs on that debt. But there are no signs of it now, and it is just possible that a sustained strong US economy could eliminate the budget deficits, even generate surpluses in revenues (taxes) that, if not spent, could go to pay down debt.
It is highly likely that the Federal Reserve will raise rates at their next meeting mid-December. The recent rout in bonds probably has more to do with this expectation than it does with the uncertainty over Mr. Trump’s tax-cutting and spending plans, as they remain undefined.
State (tax-free) municipal bonds have been especially hard hit these past few weeks as interest rates have risen, but also because their tax-free appeal will be eroded somewhat if Mr. Trump is able to lower income taxes substantially.
Another dynamic in the bond market revealing optimism about the economy is that the yield on both high and low grade corporate bonds has risen slower than on Treasurys. That means the prices of corporate bonds have dropped less than those of government bonds. Investors are betting that economic conditions will continue to improve, ensuring that firms will be able to pay their debt. According to the WSJ, the premium investors demand for debt that is riskier than risk-free Treasurys is down to 1.34%. The spread peaked this year at 2.2% in mid-February.
Given what many may call a near-certainty that interest rates will rise in the next couple of years, why not sell bonds, specifically our Treasurys? It’s a good question and one we take seriously. If our purpose for owning Treasurys was merely to enhance the growth prospects of our portfolios with assets that did well when stocks did not, we might be compelled to remove them when we were relatively sure they would be a drag on growth given Mr. Trump’s spending plans and Ms. Yellen’s (Fed Chair) plans to increase rates.
But we own Treasurys for a more important reason: INSURANCE. When the world is falling apart and stock and other risk investors are running for the exits, they flee toward US Treasurys more than any other asset on the planet. When investor uncertainty and fear replace optimism, Treasurys’ prices can soar to offset falling stock prices in your portfolio and reduce its volatility. Furthermore, Treasurys are great insurance because we are paid interest to hold that insurance, offsetting the risk of temporary price declines due to rising interest rates. Take a look at the WSJ chart below to see how interest rates on the 10-Year Treasury have fallen (as their prices rise) following rate spikes over the past 8 years.
Think of periods like these, when we are pretty sure interest rates are going to rise, as an insurance premium coming due. Just as we might re-examine the need for our life, disability, or property insurance policies each time their premiums come due, we are highly unlikely to cancel them if we still feel the needs for those policies still exists. I ask in all sincerity, is our world now sufficiently safe to cancel some or all of the insurance you hold on your life savings?
Today’s markets are sounding a pretty optimistic tone for the economy ahead. While some may feel it is like so many bubbles of the past, the fundamentals argue against it. The US government, by all reports, is about to open the spending spigots for billions of dollars to rebuild our infrastructure and military. They are also poised to launch massively cut taxes and regulations. The Federal Reserve has openly expressed their optimism of the current strength of the economy. These are powerful forces that under-pin movements in the stock and bond markets. Could it all blow up sooner than later? Of course. That’s why we keep the insurance, right? But it’s highly likely that the powerful forces about to be unleashed on our economy will have the planned impact of getting this economy growing at rates closer to its potential. If the Fed does a good job of raising rates fast enough to contain inflation risks without quashing growth, and if the Congress balances spending with savings, along with a whole lot of other ifs, then the stock and bond markets might just have it right.