Friday’s stellar jobs report was the icing on the cake for what was a pretty intense, yet satisfying week on Wall Street – one where US Treasury bonds took the dive investors were preparing for, Greece officially missed the first IMF payment in recent history but stated it would make the next one, and the ECB kept interest rates and the focus on quantitative easing unchanged. At this point, it’s extremely difficult to argue against the employment momentum the US is showing – it added 280,000 jobs in May, revised April upwards, and also showed a greater-than-expected wage growth of 0.3%. As expected, the S&P 500 remained mixed on Friday following the report, with investors digesting the fact that the good economic news would pave the way for interest rate hikes. CME’s FedWatch is now indicating a 50% probability of a rate hike in the October 28th Fed meeting, and the current state points to a fascinating few weeks ahead – one where fundamentals collide with behavioral economics, and rational markets along with monetary policy. Predictions of when and what the returns will be is a tough, tough game, but this situation is too interesting to not outline. Here’s what’s on our mind as we check out Wall Street:
– Historical Rate Hike Returns: The major worry we have had regarding the bond market came true this week, with US Treasury yields jumping nearly 30 basis points to end the week at 2.4% (a massive upturn, for those not as familiar with bonds). The Dow Jones US Utilities sector also ended down 4%; with the sector acting as a a proxy for bonds due to their dividends and safety, it’s clear that investors are preparing for higher rates. A rising interest rate, as is, indicates a stronger economy, and in our opinion, the (extremely accomodative) Fed wouldn’t go for it unless they really believed the economy was ready. A look at 10 year T-bond yields as an indicator of GDP growth also aids the theory that rising rates might be a positive sign for the US economy. Now, combine this with stock returns – according to data starting from 1983 from Nuveen Asset Management’s Bob Doll in Barron’s this week, the average performance of the S&P 500 in the past 6 rate hike cycles was +14% from 250 days before (one trading year) the first hike, only +2.6% one trading year after, and +14.4% 500 days (two trading years) after. So, historically, stocks have actually done fairly well – although with higher volatility. Another key point, according to him, is that “during the previous six rate hike cycles, the Fed Funds rate started at an average of about 5%”, and the “10 year T-bond yield was around 7% on average”. That’s a far, far cry away from today’s near-zero Fed Funds rate, and 2.4% T-bond yield. We’re starting on a very low baseline, and this should definitely help keep investors somewhat calm.
– The Return Of The Consumer: At the same time, risky assets – such as stocks – have been massively driven up by investors since 2009, seeking yield in a slow-growth global environment. Today, the S&P 500 finds itself at 17.1x forward earnings, according to Yardeni Research. In our opinion, it’s inevitable that investors will take some profits when interest rates start hiking – likely in Q2 or Q3. However, the economic fundamentals remain sound, and a bounceback in Q4 is what we’re looking forward to due to pent-up consumers. This is because personal savings rate has reached 5.6% (a multi-year high), and people have been busy paying off debt so far, instead of spending. We certainly don’t think oil prices are going to skyrocket anywhere soon, given that supply (based on OPEC’s meeting last week) remains unchanged, supertankers continue to get paid massive surcharges to transport oil – which means the supply gut continues, according to a fascinating report by Bloomberg, and therefore, the savings derived from gas prices will remain around. This should help consumption in the coming months as the labor market tightens, inflation grows, and the US dollar continues to remain strong (helping small businesses – which employ over 90% of the US population, according to the Census Bureau, and derive most of their revenue domestically). So, consumption should drive growth later in the year.
– Earnings Revisions: In Q1, given the downturn of oil, the massively conservative earnings estimates by Wall Street led to an S&P 500 earnings outlook much lower than it deserved, in our opinion. Looking at FactSet’s Earnings Insights last week, we noted that ‘companies in the energy (+28.8%) and Healthcare (+10.7%) sectors are reporting the largest upside aggregate differences between actual earnings and estimated earnings’. We feel that analysts continue to be cautious in increasing estimates for the remainder of the year – even though oil has bounced back and is holding steady at around $58 (WTI crude, July contract). Our point? Earnings estimates stand a very high chance of revisions upwards as the year goes on – and therefore, our concern of limited multiple expansion from the current 17.1x forward earnings for the S&P 500 is pretty low – it would be higher earnings driving returns instead.
What it means for you: The US economy is looking pretty good. Sound fundamentals provide no reason to penalize a market that is currently being aided by immense liquidity – so if it falls when that crutch is removed via interest rate hikes, give it a hand back up by buying sectors on the cheap. Wall Street can appear intimidating in the short term, but it has definitely proven to be a faithful companion in the long term, rewarding loyal investors that stick with it during the ups and downs of life in the markets. Keep looking into the details and fundamentals at the forefront of your investment decisions as monetary policy starts engulfing the news in the coming weeks on Wall Street.
