Source: FactSet estimates
The Federal Reserve (Fed) is now clearly in a tightening cycle. The Fed raised interest rates during the quarter by 25 basis points. Not long ago that would have been the headline for our quarterly commentary. This quarter, however, the Fed has clearly taken a backseat. The markets – both stock and bond – barely budged on the rate news, even though early in the quarter investors hadn’t discounted the change.
The Trump administration looks erratic and we expect it to stay that way. With the ACA reform stalled, Trump is turning to tax reform, which could prove positive. On the other hand, the defeat could mean that Trump fiscal policy is less likely to be effective, resulting in a potentially watered down version of tax reform. Political outcomes are hard to gauge from any administration. With the new President we think it will remain difficult to distinguish the true progress from the noise.
The U.S. yield curve flattened and long-term U.S. Treasury yields were lower at the end of the quarter while short-term rates rose with the Fed rate rise. Corporate bond spreads were narrower in the quarter, but had sold off (widened) from their tightest levels in March as prospects for a fast start from Trump and the Republicans began to fade. The Fed raised rates in March and investors now believe there is at least one more rate rise this year, coming as early as June.
Corporate and other non-government bond issuance remained strong in the quarter. However, the Republican proposal for corporate tax reform could have significant impacts on debt and fixed income markets in the future. In particular, the proposal to eliminate the deductibility for corporate interest would significantly raise the cost of capital for high yield bond issuers and could reduce the attractiveness of debt to investment grade companies, enough so that issuance could fall. We continue to track closely the developments with the Trump and Republican proposals as they could have significant impacts on business models for the companies in which we invest.
While investors expect interest rates to rise, induced mainly by better economic results and the Fed in a tightening cycle, overall yields still look relatively attractive, particularly for international investors whose home country yields in Europe are very low. Also, bond yields now rival dividends. The 10-year U.S. Treasury is now yielding more than the S&P 500® Index.
U.S. stock indexes hit new all-time highs and earnings multiples expanded to where price/earnings (P/E) ratios far exceed the historical average. The S&P 500 Index is up about 10 percent since the election and trading is at one of the highest forward P/E ratios since the internet bubble.
Year-over-year earnings growth has been positive. The upcoming earnings reporting cycle is key to whether the positive momentum continues. While the market was strong for the quarter, it faded in March as the Trump and Republican agenda stumbled. As market direction has shifted from the Fed to fiscal and tax policy, the key to further improvements lies with the administration and legislature. Despite the missteps by the administration and the high degree of political noise, stock volatility as measured by the VIX has remained historically low.
Utility stocks were another surprise. Traditionally a defensive sector, utility stocks were one of the best performing sectors in the quarter despite the expected rise in interest rates. Low or negative rates overseas may have brought foreign investors to U.S. bond-like substitutes in the stock markets such as utility stocks.
Real estate stocks barely budged in the quarter due to rising interest rate expectations. Real estate fundamentals are slowing but still positive. Demand for private real estate continues to be healthy and there hasn’t been a change in private valuations with the rise in interest rates since the election.
The Real Estate Investment Trust (REIT) market is exhibiting a typical late cycle pattern with a slow-down in supply and tightening lending conditions. The retail real estate segment has been hit with recent store closures and bankruptcies. As consumers shift more of their purchasing online, retail storefronts are being replaced by warehouse fulfillment centers at much lower costs, boosting demand in the industrial real estate sector.
Multifamily properties could pose potential issues, particularly on both the east and west coasts, where rents are expensive. Thus far, strong job growth in high paying sectors hasn’t accompanied the supply of upscale apartments in these areas.
Our optimism about the economy and markets remains, but it has been dented somewhat by the slowed political agenda. We believe growth will surpass that of 2016, but it is unlikely to be the 3-4 percent that Trump promised. Lower taxes, looser regulation and generally more business friendly policies have the potential to lead to growth. If enacted, the pro-growth policies should extend this already long business cycle. However, the realism of what it takes to run Washington is settling in on the markets.
While our outlook for growth remains positive, there is strong potential for trade and immigration proposals to lead to more inflation. Inflation measures have already turned up in the U.S. as well as in Europe, surprisingly. Immigration may crimp labor supply and trade policies could turn protectionist, raising both labor and import costs.
Corporate tax reform has the potential to substantially impact companies’ business models. Challenges include the complex border adjustment tax that favors exporters and hinders companies that import the goods for sale in the U.S. Apparel retailers have already been impacted by these prospects.
For much of the last eight years, Fed policy has overshadowed the economy and fiscal policy in propelling the markets. Now it looks as though the economy and the government’s policies could supplant the Fed for market leadership. For investors to truly take this to heart though, the government will have to show it can really get something done.