Review of Second Quarter
The last three months continued the trend of strong returns and stable markets. The S&P 500 rose by 3% for the quarter. International stocks did even better, with developed market stocks increasing by 6% and emerging market stocks rising by 4%. Despite the rate increase by the Federal Reserve, bonds went up by 1%.
Below is a table showing key economic and market indicators (as of June 30)*:
The overall picture is that the economy remains strong. Corporate profits were expected to rise significantly throughout the year, and the profit figures released in April and May were even better than expected. The only negative is the slightly higher-than-average level of the price-earnings ratio – but the key word is “slightly.”
Bond Market Outlook
Normally we focus more attention on the stock market and less on bonds – because stocks are typically more exciting. This quarter we’ll flip the order and emphasis, because there’s an interesting trend happening for bonds that may be affecting stocks as well.
Throughout this decade, until a few months ago, the Federal Reserve forecasts of interest rate increases had been unreliable. A typical year would have the Fed forecasting an increase in short-term rates by 1% over the next year, and then not following through. Late in 2016 the Fed started to provide more transparency into their decision-making, and predicted three ¼% increases over the next year, depending on the level of economic growth. They’ve met their forecasts, with increases in December of 2016 and March and June of this year. From our observation, this provides a lot more confidence by analysts in the direction of rates going forward. Hence, despite the recent increases, five-year rates remain very low, and bond markets have been relatively stable.
We might be entering a new paradigm for bond markets. The sustained level of interest rates on U.S. government bonds is at its lowest point in history (of course, when Alexander Hamilton first issued Treasury bonds, the U.S. was essentially an emerging market economy). Along with most analysts, we always expected intermediate-term interest rates to eventually return to their pre-recession level of at least 4%. Now, we’re not so sure about that.
We still believe investors should stick with short- and intermediate-term bonds. Even if our forecast is only for modest interest rate increases, the risk versus return relationship does not support investing in long-term bonds. 30-year bonds earn an additional 1% in yield over five-year bonds, but the daily price fluctuations are over four times as high. It is not worth taking on such additional risk to gain a relatively small amount of yield.
We remain watchful, but not overly concerned, about above average stock market valuations for long-term investors. Two factors that theoretically and empirically have been shown to support high valuations are 1) low volatility and 2) low interest rates. As we just explained, the low level of interest rates might persist for some time. We might get worried If price-earnings ratios grew to a level of over 20, but they are nowhere near that point.
Over the past few weeks there have been signs of small increases in volatility. Some of it is related to political issues, but the daily price fluctuations are still well below long-term averages. While we recognize we’re being repetitive, it would not surprise us if volatility continued to pick up. Such an increase would not cause a change in our investment recommendations for long-term investors – nonetheless, investors should be braced for such a change.
We’ve had a high degree of stability of economic conditions and monetary policy. That’s been good for both the bond and stock markets, and returns over the past twelve months have reflected that stability. Of course, we don’t have a lot of clarity with respect to economic policy and political direction – there’s still not been a meaningful act of legislation impacting our economy this year. However, as we’ve mentioned in past commentaries, presidential politics has had a muted impact on capital markets in the past. The strong market conditions might be further evidence of the lack of impact on presidential policy on stock markets.