Hesitancy Looms over Financial Markets
U.S. government bonds have been on a bit of a ride. Late in February, they rallied, and the U.S. ten-year Treasury yield fell to 2.313%, its lowest close since November 29, 2016 (bond yields move inversely to their price). Then, the U.S. ten-year Treasury yield pushed back up to 2.6%, in tandem with investors’ expectations that the Federal Reserve (Fed) will raise interest rates on March 15. And, when the Fed did in fact raise interest rates, yields fell again due to slightly dovish undertones. The movement in bonds helps us to gauge investors’ expectations, which are seemingly range-bound – supported by U.S. economic prospects, but also restricted by hesitancy looming over financial markets.
After Sharply Shifting Higher, U.S. Bond Yields Have Remained Flat
Source: Bloomberg, as of 3/16/2017. Past performance is no guarantee of future results, which will vary. Treasury securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
A strong economy and expectations for tax cuts, infrastructure spending, and relaxed regulations drove U.S. equity markets higher, following the election. Recently, however, the same enthusiasm, which elevated markets, slowed – sending markets into a lull of lethargy. Trading volumes are relatively low, when compared to last year. Upside moves are minimal, and the S&P 500 has resisted a 1% decline for more than 100 days, a rarely accomplished feat. Likewise, equity market volatility is uncharacteristically low.
There are still many signs that investors are fairly bullish on the economy, and rightfully so. In stark contrast to this time last year, indicators of economic acceleration abound in the U.S. and elsewhere. Unemployment rates continue to fall, manufacturing activity is elevated, capital expenditures are up sharply, and corporate revenues and earnings are rising. The trajectory of U.S. Gross Domestic Product (GDP) is currently onwards and upwards (see chart below).
U.S. Gross Domestic Product (GDP) Estimates Show Increasing Growth
Sources: Federal Reserve Bank of New York, Bloomberg, as of 3/16/2017. Last data point, 3/10/2017. The Federal Reserve Bank’s Nowcast is a predictive estimate of GDP growth for the current quarter, based on economic data as it becomes available.
The Federal Reserve also notes the upturn in the economy. This week, as expected, members voted to increase the target interest rate, citing solid job gains, rising household spending, and firming business-fixed investment. The data-dependent Fed also appears set to hike rates at least two more times this year, given the backdrop of improved growth and signs of mounting inflation.
The new President of the United States was certainly dealt a good hand, and markets have fully supported his growth-friendly initiatives to date. But, rumors out of Washington indicate that Capitol Hill’s calendar may be overstuffed. The administration’s lofty goals and massive asks are far from the pace and scope by which Washington typically operates. Already three months into the year, investors are skeptical about how quickly these policies can be enacted.
Additional distractions from pro-growth fiscal policy have also impacted investor sentiment. In the very early days of his administration, President Trump has taken a hard stance on trade negotiations. Continuing too far down this road could be very damaging for all parties involved. Immigration policy, too, has been met with some concern, as it has the potential to drag on economic performance.
All this being so, there is ample cause to remain enthusiastic about the outlook for U.S. equities. Our base case scenario for the year ahead calls for returns in the mid- to high-single digits with a caveat – the potential for still higher returns. If fiscal support does, in fact, make its way through Congress this year, if investor enthusiasm holds, and, if a secular rotation from bonds into stocks occurs, then the potential for far greater returns becomes increasingly likely.
Though less likely, in our view, there is also the potential for prices to move in the other direction. While confidence is currently high, it remains elusive. Any failure by the administration to deliver on key elements of the pro-growth campaign platform could cause investor sentiment to swiftly swing from high to low. Trade and immigration entanglements could also lead to unfavorable outcomes.
It appears increasingly likely that extreme outcomes could be more likely than we may have expected. We like to refer to such a phenomenon as a fat-tail distribution. And, some argue that investors may be mispricing the cost of these fat tails – in other words, they are unprepared. With short interest on the S&P 500 and the CBOE Volatility Index (also known as a fear indicator) near its low, a large movement in either direction would certainly surprise investors.
For those looking to take advantage of these fat tails, buying long calls could potentially capture any upside movements, while puts could help hedge downside risks. For those investors who avoid derivative products, convertible bonds could offer some protection from those downside moves, while also providing some equity exposure on the upside.
All in, we have a moderately positive outlook for U.S. stocks, while bolstering our portfolios for those large moves in either direction. We are rather less confident when it comes to Europe. Growth has certainly increased, and valuations are generally attractive, but the risks seem plentiful, as the eurozone is in question. So, we have adopted a home-country bias, tilting our portfolios to favor the U.S., particularly shares in small- and mid-cap companies, whose businesses are relatively well-shielded from turbulence abroad and the effects of a strong dollar.
All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. Small- and mid-cap stocks are often more volatile than large-cap stocks. Smaller companies generally face higher risks, due to their limited product lines, markets, and financial markets.
The information and opinions herein are for general information use only. The opinions reflect those of the writers but not necessarily those of New York Life Investment Management LLC (NYLIM). NYLIM does not guarantee their accuracy or completeness, nor does New York Life Investment Management LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice.
There can be no guarantee that any projection, forecast, or opinion in these materials will be realized.
S&P 500 Index – Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.
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