Stocks and Bonds Enjoying a Relaxing Summer

Both stocks and bonds have been doing well into the summer as investors digest mostly positive second quarter earnings reports, good economic data, and a lack of market-moving bad news from the geo-political front.  U.S. large-cap stocks, as measured by the S&P 500, are hovering near their all-time highs.  The gains, however, have been concentrated in just a handful of giant technology stocks, which by some calculations have accounted for roughly 40% of the increase in the overall market since the beginning of 2017.

Despite the political gridlock in Washington, the economic backdrop in the U.S. continues to be supportive of both stocks and bonds.  Today’s report that our economy added 209,000 more jobs in July will only further bolster investor confidence.  The unemployment rate now stands at 4.3%, the lowest level in 16 years.  The slow but steady growth in the economy, combined with increasing corporate profitability, may continue to promote an environment of relatively low volatility coupled with attractive equity returns.  Some investors fear an end to the run in stocks because of the length of the current bull market—now eight years and counting—but the sluggishness of the expansion has undoubtedly also contributed to its longevity.  The slower-than-average recovery has allowed companies plenty of time to get their cost structures in line.  Thus, corporate earnings may continue to grow for several more years to come.  Most bull markets end with some sort of a build-up in excesses (usually debt, inflation, high valuations, and or ebullient investor sentiment) but the current environment does not exhibit any of the obvious warnings signs or excessive investor optimism that often signal the end of a rise in equities.  While equity valuations are above long-term averages, so too is the earnings growth rate that has supported the recent performance of equities.

Earnings are Driving Stocks Higher

The main factor driving stocks in 2017 is what is usually the single most important source of sustenance for stocks: corporate earnings.  For the second quarter of 2017, U.S. companies are set to post what will likely be the second consecutive quarter of year-over-year double-digit earnings gains, something they have not done since 2011.  And they have done so without anything happening in Washington on the three policy fronts that will potentially further bolster their earnings: deregulation, corporate tax reform and increased infrastructure spending.  Interestingly, the “Trump trade,” which favored investment in domestically oriented companies (such as small-caps), energy and industrial companies, but which did not favor technology or healthcare, has not worked in 2017 as it did in the closing weeks of 2016.  For now, investors are enjoying broad-based earnings growth in every S&P sector except for utilities and do not seem to be expecting much help from Washington.

The ten-year U.S. Treasury note yield today sits at 2.26%, 19 basis points lower than where it started the year.  Thus, high-grade debt has also delivered a constructive performance so far in 2017.  That being said, the economy is probably strong enough for the Federal Reserve to continue to gradually hike rates through 2017 and into 2018.  The advance estimate of second quarter gross domestic product growth, according to the Bureau of Economic Analysis is 2.6%, a decent performance and a sizable improvement over the 1.2% (revised) gain in the first quarter of 2017.

Exogenous Forces

With valuations on the high side, the economy on a constructive path and investors feeling good, the equity markets are potentially vulnerable to exogenous shocks from numerous fronts.  Simmering issues include a potential showdown with North Korea over its expanding nuclear weapons delivery program, worsening relations with Russia over sanctions and Ukraine, a trade war with China or destabilizing developments out of Washington regarding former FBI Direct Mueller’s Russia investigation.  That all being said, investors seem for the moment to be assigning a relatively low probability for any of these issues to derail the current economic and equity market momentum.

Please do not hesitate to contact me if there is anything about the markets or your portfolio that you would like to discuss.