Year to date, financial markets have seen more action than in all of 2017. A year that began with talks of an overextended business cycle and elevated valuations across US asset classes concluded with the passage of tax reform, sending business sentiment soaring and corporate earnings along with it. It was a year which saw the S&P 500 close at 62 record highs (Source: CBS News) and deliver some of the best risk adjusted returns in history amid rock-bottom levels of volatility. Enter 2018. Companies are earning record profits, returning unprecedented amounts of capital to shareholders, and volatility is back to more normal levels. Every day, headlines pertaining to threatened tariffs, revised regulations, and Federal Reserve policy fill the news; stock prices move erratically and what matters most to the market seems to change daily.
Source: MarketWatch, Pension Partners
Is the economic landscape really so ambiguous, or are the markets playing a game of what I like to call “narrative tug-of-war”? In narrative tug-of-war, markets may react differently to the same news when presented on a different day, selectively choosing when to act on or ignore a given data point. Lately, much deliberation has revolved around the Fed, so let’s look at several of the narratives surrounding rising interest rates, which may or may not be accurate:A 3% US 10-year treasury yield is bad for stocks: The US 10-year treasury broke the psychological 3% barrier for the first time in over 4 years on April 24, 2018 (Source: MarketWatch). On one hand, as long-term rates rise borrowing costs and debt servicing burdens increase. However, rising long term interest rates (i.e. the 10-year note) signal increasing growth and inflation expectations, two factors that typically coincide with economic expansion. In just over a month since then, the S&P 500 has returned north of 3%.
Elevated short-term rates steal demand from equities: In our opinion, this narrative has some validity. As short-term rates increase, they start to become more attractive relative to the dividend yield on equities, suggesting investors will shift their allocations from stocks to short-term bonds and collect a fixed rate of return without bearing the associated risks of equities. This must be weighed against the opportunity for further stock price appreciation. In December, the 2-year U.S. treasury yield surpassed the S&P 500 dividend yield for the first time since 2008 (Source: The Wall Street Journal). The S&P 500 has traded sideways since this milestone was reached.
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S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market.
Investors cannot invest directly in an index. Past performance is no guarantee of future results.
Earnings Score = proprietary calculation from Earnings Scout those indicates the rate of changes of forward EPS estimates.
A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP).
Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth.
The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. The Federal Reserve System is composed of 12 regional Reserve banks which supervise state member banks. The Federal Reserve System controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy.
The yield curve is a graph that plots the yields of similar-quality bonds against their maturities, enabling investors to compare the yields of short, medium, and long-term bonds.
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment.