Written by: David Nelson, CFA CMT
Investors from Wall Street to Main Street concerned there's a potential disconnect between the market and the economy are asking some tough questions. The five largest stocks by market cap represent 23% of the index. I doubt the fortunes of Apple, Microsoft or Amazon represent what’s taking place in your local community. Is it the absolute level of economic activity and employment, or is it enough that the numbers are heading in the right direction to justify current prices? In the face of those concerns, the S&P 500 has taken out resistance at 3393 breaking to all-time highs forcing investors to ask: What’s Next?
We all understand that equity valuations are stretched but we also know that valuations don’t exist in a vacuum. Relative to other asset classes, equities still look attractive, especially when you consider the S&P 500 dividend yield is 1.7% —significantly more than what is available in US treasuries.
What we don't know, however, is just how far can we push the envelope? While the Federal Reserve controls the short end of the curve and has promised to keep rates lower for longer, yields for long dated maturities are set by fixed income investor demand. Key data points for the fixed income investor are credit quality, inflation expectations and yields relative to other risk-free assets, in that order. Let's tackle the last two first.
U.S. vs Europe Benchmark Yields
Most of Europe offers 10-year yields at zero or less. Fixed income for much of the developed world is less competitive than the United States.
Even with the Fed balance sheet just shy of $7 trillion, the dollar is still the reserve currency and U.S. Treasuries top the list of safe-haven assets. What could change that? Increased political risk here at home or another devastating shutdown of the US economy would top my list of investor concerns. Minneapolis Fed President Neel Kashkari, in a surprising statement to CNBC, said he would like to see a government shutdown of the US economy for at least six weeks.
The next stimulus package will be at least $1 trillion on top of the $2.2 trillion CARES Act already earmarked. Add the fact that Federal Reserve has increased its balance sheet another $3 trillion just this year, and we must ask ourselves just how far can we take this line of thinking?
Inflation expectations have been picking up and we have seen fixed income proxies like the iShares 20+ Year Treasury Bond ETF start to roll over. Since the start of August, 10-year yields have risen from 50 bps to 72 bps.
The danger for U.S. equity investors is fixed income yields becoming competitive. For the moment, outside of gold, stocks have had little competition and, even with valuations stretched, as long as economic output was in the right direction, investors have been happy to bid up their favorite stocks.
U.S. Yield Curve
As I said before, the Fed controls the short end of the curve and has anchored the Fed Funds rate to zero for the foreseeable future, but as you can see in the yield curve chart above the long end is on the rise. The steepness of the yield curve implies increasing economic output, a welcome sign, but at some point, higher yields in fixed assets become a danger.
In the 4th quarter of 2018, we learned that lesson the hard way when 10-year yields started to break above 3%. Suddenly large financial players like insurance companies could match assets with liabilities using AA corporate paper and started the process to de-risk their portfolios pulling money out of stocks and into bonds.
S&P 500 side by side with U.S. 10-Year Yields 2018
72 bps is a long way from 300 but each step higher in risk-free asset yields puts increased pressure on valuation multiples. Growth will have to be more robust to sustain prices if stocks start to get some competition.
The economic calendar is heavy this week with ISM Manufacturing and Construction Spending Tuesday and of course at the end of the week August payroll numbers.