Investment Update

It was a good quarter for both stocks and bonds, adding to the solid returns of the first quarter. Numerous equity indices ended the quarter at or near record highs, in spite of a relatively flat month of June. Stocks, broadly speaking, have now posted seven consecutive quarters of positive returns.

Key Storylines for the Quarter:


Strong stock returns notwithstanding, this was not the way the first half of the year was expected to look.

The initial enthusiasm behind the new administration’s pro-growth policies fueled expectations of an immediate acceleration in economic growth, higher interest rates, stronger performance from more economically sensitive companies, and a pick-up in inflationary pressures. This was dubbed the “reflation trade.” Instead, just about the opposite has happened this year, but stocks have persevered, nonetheless.

The support for higher stock prices came from stronger earnings growth, providing a cushion from a softer economic backdrop and recent political developments.

The stock market has done an admirable job of staying focused on improving corporate fundamentals and not being distracted by the day-to-day political noise. While the hopes for near-term tax reform, deregulation and new infrastructure spending have diminished, eventual progress in these areas is still seen as an important opportunity. For now, stocks may be reflecting more modest changes occurring over a longer timeframe.

As a result of the reflation reset, investment flows continued the rotation that began last quarter from cyclical “value” stocks to secular “growth” stocks, causing a wide dispersion between the performance of value and growth strategies this year.

Technology stocks, followed by Health Care stocks, have provided the strongest market leadership year-to-date. These sectors are traditionally less dependent on the economy to achieve their own growth objectives. Many have noted that the largest of the tech stocks (Apple, Google, Facebook, and a handful of others) have become too large and too popular, causing concern of another tech bubble. These stocks have also represented a disproportionate share of the year-to-date gains inside the major benchmarks.

“Crowded trades” of any kind can take on their own momentum and chasing performance always risks pushing values to unsustainable extremes. A near-term pullback in these tech favorites would certainly not surprise, especially given the short-term nature of momentum-based investment strategies. But unlike much of the speculative activity that occurred in many tech stocks in the dot.com era, the current tech favorites are generating strong earnings growth. If that continues, in spite of very high valuations, these stocks may remain attractive to investors, particularly should the broad economy continue to perform sluggishly.

In addition to earnings growth, stocks continue to be supported by low interest rates and accommodative monetary conditions around the world. There has also been a pick-up in economic activity outside the U.S., boosting the earnings of U.S. multinational companies.

Low interest rates were supposed to be yesterday’s news, given the longevity of this eight year plus bull market, but old habits die hard. Much attention has been paid to what’s called a “flattening of the yield curve” – when short-term interest rates rise (a function of Fed rate hikes) and at the same time, longer-term interest rates decline (driven by bond investors’ reduced confidence in the economy and lessening fears of future inflationary pressures). This flattening is often a precursor to economic slowdowns. So far, stocks have not been troubled by the bond market’s more dour view of the future, but eventually, stocks will need more than low interest rates to support further gains from today’s record highs.

Outlook:

As investors look to the second half, a few conflicting signals suggest increased uncertainty.

  • As noted above, stocks and bonds share a different outlook on the economy, but that is not all that unusual. Still, some reconciliation between these bifurcated views will inevitably develop in one direction or the other.
  • The Fed’s plan for additional rate hikes belies the prolonged weakness showing up in inflation data. Stocks suffered a legitimate correction (Q1 – 2016) the last time investors believed the Fed’s plans to raise interest rates were too aggressive.
  • The historic low volatility of the stock market this year has not squared with the higher level of political and geopolitical uncertainty. This seems less a case of investor complacency than it is a measure of investor focus and discipline.
  • While the recovery in the energy sector has contributed to the earnings growth story, the recent decline in crude oil prices has reminded investors of the destabilizing effects of oil dropping below $40/bbl. The first signs of concern, though, have not yet shown up in a widening of credit spreads (interest rates moving higher on lower quality debt).

It is said that bull markets don’t die of old age. Fortunately, business cycles are not defined by their age either.

It is generally acknowledged the current sub-par business cycle is largely the result of the severity of the financial crisis that preceded it. As such, it has lasted longer than most cycles by avoiding the typical excesses of a normal recovery. The end of bull markets usually coincide with an economic recession. Our own analysis of the economy tells us that the near-term likelihood of a recession is low. From that perspective, the current cycle should have an extended life and remain supportive to stocks.

That said, business cycles don’t always follow the same script and given the unconventional progression of the current cycle, we take little for granted in how this cycle eventually ends. Low interest rates and improving corporate fundamentals can support high equity valuations for an extended period of time, and that is clearly at the core of the bull market. High valuations, in and of themselves, do not dictate the market’s direction. But they do serve as a means to measure the potential downside should the structure of this support change, possibly by way of meaningfully higher interest rates or an economic downturn. While this is not the likely case, other potentially destabilizing events, e.g. geopolitics, does suggest some incremental caution when looking forward from the perch of all-time highs. Not a bearish proclamation, but it is the natural inclination of a value-driven firm.