Stocks continued to rise through the second quarter, albeit at about half the rate of the first quarter. The large cap group had the best quarterly performance with the S&P 500 returning roughly 3%. Mid and small cap stocks increased as well but about a percentage point less than large caps.
This has put all the major U.S. indices at record levels and at pretty high valuations. Since May, there have been growing concerns regarding these valuations and questions as to whether or not the economic and legislative progress warrant the gains. One interesting aspect of the financial markets is differing message stocks and bonds are telling us.
While stocks have been gaining, bond yields are generally lower. Declining bond yields are a bearish economic indicator. This is especially true in light of the Fed tightening its monetary policy. The saying goes that the smart money is in the bond market so it’s hard to ignore these signals.
So much of the economic optimism is built on the Trump administration’s tax and regulatory agenda, which we believe in, but it’s becoming questionable as to how much of this reform will actually get passed. The reality is that GDP grew at an annualized rate of just 1.4% in the first quarter. That’s sharply down from the 2.1% we saw in the fourth quarter of last year and consistent with the sub 2% growth the country has delivered over the past nine years. Clearly, it’s too soon to judge the impact of the new administration’s policies but it does demonstrate the risks to the markets. We don’t think current stock valuations would hold up with two percent growth and rising interest rates.
Investors who feel comfortable with current stock valuations will justify them in light of the pervasive ultralow interest rates. This is true. However, these rates haven’t been market based since the financial crisis began. The Federal Reserve and other central banks have been actively manipulating these rates for a very long time now. They’ve done this directly by setting the overnight lending rate to near zero and, more importantly, by actively participating in the in the secondary bond market. This means they have been competing as buyers for the very same bonds that traditional investors normally purchase.
The Federal Reserve now owns roughly 4.5 trillion dollars of these bonds (the result of Quantitative Easing). These include treasury bonds, mortgage backed bonds and municipal debt. While they have stopped adding to their portfolio, they are still buying additional issues to replace ones that have paid down or matured in their portfolio. So, they still have a big influence on the market. And it’s not just our Fed; central banks around the world have been doing the same thing to prop up their economies.
How big is this influence? Central banks now own roughly 1/3 of all publicly traded debt worldwide. That is a fantastic statistic. It’s also a source of considerable uncertainty. This quarter the Fed finally announced their plans for how they’re planning on reducing the size of their portfolio. Nearly all Fed officials at the May meeting agreed that the central bank should start shrinking its portfolio this year, barring any unexpected changes to the economy.
Fed officials said they are leaning toward an approach that would be gradual, with monthly announced changes to the amount they intend to reinvest back into the bond market from maturing securities. Setting monthly limits for how much they can reinvest would reduce the portfolio in a gradual and predictable manner reducing the risk of market disruptions. Unwinding such a large portfolio, however, could take more than a decade. A lot can happen over that time.
For some time now we have been expecting higher rates only to be disappointed as rates have remained at historically low levels. It may sound strange to wish for higher rates as that is traditionally bad for stocks and bonds, but the flip side is that investors have been deprived of dependable sources of income for years. These central bank initiatives have distorted the market in far too many ways. For example, retirees have been forced into risky assets as a way to pay their bills. Cheap money continues to create incentives to borrow too much. Assets are hard to value and often overpriced.
This situation has persisted far too long. The financial crisis has been over for years now and it’s time for the Fed to get out of the way. So, with a new focus in Washington, hopefully we’ll see a return to normalcy.