Source: Bank of America/Merrill Lynch 2015
The markets finished the quarter with momentum as President Trump finally introduced a tax reform plan that many had been waiting to see since early in the year. It proposes to cut corporate tax rates substantially, and reduce income tax rates and complexity for individuals.
The fixed income market keeps chugging along with stable long-term interest rates and strong demand for corporate and other nongovernment bonds. Institutional and retail investors continue to put more investment dollars into bonds. Strong inflows into retail mutual funds have been one of the big surprises of the year. Demand has been propelled by developed country age demographics and a global reach for yield. We expect the continued rise in the number of retirees to support investment in safe, income-bearing investments for some time to come.
Spreads relative to Treasuries on corporates, mortgage-backed, asset-backed and commercial mortgage-backed securities narrowed again in the quarter after a brief spike in August. Spreads on high-yield corporate bonds are at or near their tightest levels all year.
Demand for nongovernment bonds remains supported by the same strong fundamentals that are supporting equities: steady growth, low inflation and strong earnings. The high demand has been met with another year of strong supply. We are expecting this to be the fifth year in a row of over $1 trillion in investment grade corporate bond issuance. While valuations appear rich, spreads are nowhere near their tightest levels reached during the 1990s. Should current conditions persist as they did then, spreads could tighten.
All major U.S. equity indices hit new highs and ended the quarter at or near those highs. Equity prices were supported by strong fundamentals as well as by a declining dollar, which makes U.S. exporters more competitive and can generate an earnings boost through currency translation. The U.S. dollar fell 3 percent during the quarter against major trading partners as reflected in the decline of the trade weighted dollar, and is down 8 percent since the beginning of the year. Growth and cyclical stocks outperformed defensive stocks. Large cap companies continued to exploit their scale advantage and overall, the U.S. large cap market has maintained record high profit margins for over two years.
Valuations in the stock market are high by many measures but remain substantially below the peak reached in 2000. While technology stocks have made up a substantial share of the market’s performance, as they did in the late 1990s, valuations in the technology sector appear to be supported by real earnings and profit growth this time around.
However, long-term market valuation measures, such as the Shiller CAPE Ratio, are raising warning signs that today’s valuation levels portend substantially lower returns for stocks in the coming decade.
At the sector level, brick and mortar retailer stocks continue to be hit hard for any miss on earnings projections.
Real Estate Investment Trusts (REITs), as measured by the Wilshire Real Estate Securities Index, were up marginally in the quarter, rising 1 percent. REITs, which are most sensitive to the success of President Trump’s policy agendas, such as health care and office, underperformed. Similarly, hotel REITs were lagging the index until the aftereffects of Hurricanes Harvey and Irma resulted in tens of thousands of displaced residents in Houston and across Florida. This short-term, transitory business caused the group to rally sharply in September.
Property sectors associated with e-commerce continue to shine, most notably data centers and industrial warehouse. As more retailers look to enhance their web presence, the shipping fulfillment necessary to accommodate online shopping has resulted in record leasing of warehouse space. In addition, grocery-anchored shopping centers made a recovery from last quarter.
REIT earnings continue to decelerate on a sequential basis, with forward year-over-year earnings growth expectations hovering around 6 percent. With occupancy levels at or near record highs across most property sectors, REITs will be more reliant on rental rate escalations than occupancy gains to deliver accelerating earnings growth.
We expect growth to remain at trend or above for the remainder of 2017 and surpass the meager 1.6 percent real Gross Domestic Product (GDP) growth posted in 2016. Third quarter GDP growth was trending in the mid-2 percent range before storm damage curtailed consumer and business activity in Texas and Florida. Consumer confidence and business confidence remain strong, as they have been for most of the year, and we expect that this sentiment will continue to support spending, investment and growth. Despite the horrible disasters from hurricanes in terms of both human life and property destruction, the impact on GDP is expected to be modest.
Falling inflation has been one of the big surprises this year, and while we could see a reversal of this trend, we no longer expect inflation to reach or exceed the Fed’s target in the near future. Wage inflation is the most important driver, and it is not substantively picking up. Where wages are rising, the costs are not being passed through to the consumer as firms are able to maintain their margins by cutting other costs to offset any rise in labor costs.
The outlook is surprisingly stable in the economy and the markets, except for the geopolitical market risk due to continued saber rattling between President Trump and North Korea’s leader, Kim Jong-un. The uncertainty of the situation dented stock gains and pressured interest rates lower from time to time over the quarter. We remain more concerned about these type of endogenous factors negatively impacting the markets than we do about a natural end to the current conditions.
After eight years of a slow recovery and expansion, we continue to see good sailing ahead for the market as the economy and markets put up steady gains into a gradual Fed tightening. We expect more of the same like we experienced in the third quarter as we move through the end of the year and into 2018.