By Justin Pawl, CFA, CAIA, CFP®
Last Week Today.
- Federal Reserve Presidents Eric Rosengren (Boston) and Robert Kaplan (Dallas) resigned amid ethics concerns over their investment trading in the early days of the pandemic. Both Rosengren and Kaplan lean hawkish in their policy views, paving the way for President Biden to appoint new Fed governors and shift the balance of power at the Fed more dovish.
- Durable goods orders rose 1.8% in August, more than double expectations of a 0.7% increase, and July’s orders were revised upward from -0.1% to 0.5%. The strength in durable goods orders indicates U.S. management teams are confident demand will remain high, expanding production capacity, which will (someday) alleviate supply chain bottlenecks.
- The Fed’s favored inflation measure, Core Personal Consumption Expenditures, rose 0.3% in August, slightly above the 0.2% consensus forecast. Core PCE is now running at 3.6% on a year-over-year basis, the highest level since 1991.
- Consumption rose in August but was revised much lower in July such that Q3 consumption is tracking at about 1% (down from 2.2% the previous month).
- The September ISM Manufacturing Index rose from 59.9 to 61.1. Any reading above 50 is considered expansionary and results above 60 are rare. However, rising supplier delivery times were the largest contributor, which is less a source of strength than an indication that supply chain bottlenecks are getting worse again.
- After a heavy week of economic data, the Atlanta Fed’s GDPNow model’s forecast for Q3 GDP growth ratcheted down from 3.2% to 2.3%. Slowing growth and waning fiscal stimulus should reduce monthly inflation readings by the end of the year, but the year-over-year comparisons will remain high well into 2022.
- Global equity markets declined by more than 2% last week, capping off a September to forget for investors. The S&P 500 fell 4.7% for the month, while international stocks fared slightly better but were still down 3% – 4%. Growth-oriented stocks took the brunt of the pain, with the Russell 1000 Growth Index falling 5.6% as higher interest rates took some of the air out of inflated valuations. In the “hasn’t happened in a long time” category, the Russell 1000 Value Index is now outperforming the Growth index 17.6% vs. 15.5% on a year-to-date basis. Please click on the table below for detailed weekly, MTD, and YTD asset class performance.
- “I didn’t like last week’s Huddle,” a friend said on Tuesday evening as we watched our son’s school football practice. “You wrote that the S&P 500 hadn’t declined by 5% in more than 200 days. Today it fell 2%. You jinxed it,” he said jokingly (I think). I mentioned that I had brought up that statistic in prior weeks, and the market hadn’t declined, tipping my hat to the remarkable resilience of the stock market even with rising Delta infections, new lockdowns, labor shortages, snarled supply chains, product shortages, and higher prices in most things we all purchase. Indeed, thus far, 2021 has been an unusually calm year in the markets as market pullbacks in the high single digits to low double digits are not the exception but rather the norm. The chart below is one of the best at depicting this inconvenient truth about investing in equities (the red dots represent intra-year drawdowns, and the bars represent year-end performance). Nevertheless, even though equity markets experience occasional setbacks, they generally produce positive annual returns. The key to investing success isn’t necessarily forcing yourself to sit through white-knuckle drawdowns but instead positioning your portfolio in advance to avoid white-knuckle syndrome. In other words, be intentional in your portfolio allocations such that you only carry as much equity risk as necessary to avoid succumbing to the desire to liquidate your portfolio when the next inevitable market panic surfaces — more on this topic below.
Higher Rates & Stocks. In the week following the Fed’s meeting on September 22nd, the yield on benchmark 10-year U.S. Treasury bonds rose 20 bps. A 0.2% rise in bond yields doesn’t sound like a lot, but that was a swift move in the bond world and represented a 15% change in interest rates (1.3% à 1.5%). When yields quickly rise, equities often struggle. Sure enough, when the 10-year yield crossed above 1.5% on Tuesday, the S&P 500 declined by 2%. However, research from BCA suggests that interest rate spikes only temporarily impact stock prices so long as interest rates don’t rise to a level that restricts economic activity. The table below highlights periods where interest rates rose by 1% or more over relatively short timeframes and the S&P 500’s coincident performance. The takeaway is that while interest rate spikes often create short-term market weakness, stocks tend to recover (far right column).
But equity valuations are high, and therefore isn’t this time different? Equities are not cheap, but relative to bonds, they still trade at a discount, which brings us to the concept of “Equity Risk Premium”. The Equity Risk Premium is the excess return earned by an investor when they invest in the stock market vs. investing in a risk-free asset (e.g., a U.S. Treasury bond). Because stocks are riskier than guaranteed payments from government bonds, investors demand a higher return from equities. The Equity Risk Premium is theoretical because no one knows how equities will perform in the future. Still, analysis of historical data suggests that elevated Equity Risk Premium levels correspond with future equity outperformance over bonds.
Because stock prices are ultimately driven by earnings, one common method for calculating the Equity Risk Premium is to measure the difference between the earnings yield (earnings divided by stock price) and the inflation-adjusted bond yield. For the MSCI All Country World Index, the gap between the earnings yield and global real bond yield is 6.4%. In the U.S., where stock market valuations are more expensive, the Equity Risk Premium gap is 5.8%. Both global and U.S. Equity Risk Premiums (left-hand chart) are high by historical standards because while Earnings Yields are modestly elevated (middle chart), bond yields remain very low (right-hand chart). In sum, historically low bond yields are the primary driver of today’s Equity Risk Premiums, which says more about the potential investment returns from bonds than it does for equities.
Source: BCA Research
While the Equity Risk Premium suggests equities will outperform bonds, investors should not expect the same level of equity returns of the last few years. For example, the S&P 500’s forward Price-to-Earnings multiple is 20.7x – the highest level in the previous 25 years except for the Dot-Com Bubble (the 25-year average forward P/E multiple is 16.6x). Valuations outside of the U.S. are also higher than their historical averages, but not as rich as those in the U.S. Combined with higher Equity Risk Premiums, this suggests that after a prolonged period of underperformance, international diversification could finally benefit client portfolios in the coming years. Indeed, since 1971, the current run of underperformance for Developed International stock indices vs. U.S. stocks is the longest and the most damaging in terms of total return (U.S. stocks have outperformed by 255% since the Mortgage Crisis).
Source: JP Morgan
As for traditional fixed-income investments, the outlook is unfavorable. Real (inflation-adjusted) U.S. Treasury bond yields are already negative. The current yield on the 10-year bond is 1.46%, while the year-over-year Core Consumer Price Index is 4%, resulting in a real yield of -2.54%. Setting aside negative real interest rates for a moment, starting nominal yields are the primary determinant of bonds’ future returns. Hence, with a 1.46% expected return over the next ten years, the lift that U.S. Treasury bonds have provided to a traditional 60% equity/40% fixed income portfolio over the last 30+ years is not available going forward (unless you believe U.S. Treasury bond yields will eventually go to zero). However, even if you assign a high probability of a zero-interest rate world, it still makes sense to diversify traditional bond holdings to include higher-yielding credit instruments should your forecast prove inaccurate. I’m also not advocating for a complete abandonment of traditional bonds in most client portfolios as rates could move lower and they also serve as a valuable source of liquidity.
Nevertheless, high starting valuations for both equities and bonds imply lower overall portfolio returns in the years ahead. Lower returns also make portfolios more susceptible to downside market volatility, and low starting yields compromise traditional fixed income’s role in offsetting that volatility. In the years ahead, portfolio diversification will play a more important role than it has in the last five years as the range of potential outcomes (high inflation vs. low inflation, changes to tax laws vs. no changes to tax laws, more stimulus vs. no stimulus, etc.) is as great as it’s ever been. True diversification comes not from the number of holdings in your portfolio but the specific risk and return drivers of the assets in your portfolio. For ideas to enhance portfolio diversification, please click on this link A New Era for Fixed Income Investments.
Finally, in a lower return environment and with potentially significant changes to tax law, effective financial planning will play an important role in the coming years to ensure families reach their financial goals. In this regard, a financial advisor can be an essential ally. As with many things in life, we can often achieve our goals faster with a coach or a mentor. Elite athletes hire specialist training coaches and sports psychologists to help them reach their maximum potential. However, their potential can only be achieved when they are calm and “in the zone” during periods of extreme stress. Moreover, many successful professionals hire a career coach to help them navigate obstacles and opportunities in their business lives. Even the best of the best recognize they can benefit from an expert’s wisdom and objective advice. They rely on professionals to provide perspective and discipline during the tough times that keep them on the path to their goals. A professional advisor can serve in a similar capacity in your financial life, keeping you in the zone during periods of stress and serving as a valuable sounding board as you navigate life’s ups and downs.