Finding A New Equilibrium

Present-day US market developments are being described as the Trump trade. After-all, since last year’s presidential election, major stock market indexes went on to make new highs, earning investors approximately 6% on price gains alone.  Benchmark treasury yields returned to levels not seen in over two-years. Even the US treasury yield curve increased in steepness. Yet, is this story really about a new American President? Or could it be about the resurgence of American workers who collectively have the power to unleash American potential?

January’s payroll report showed another 227 thousand jobs were added to the economy. The official unemployment rate slightly moved up to 4.8%, because of more labor market participants. Sixty percent of the population is now employed, a slight improvement since Great Recession levels. And, job market drop-outs are at a 20-year low. 

Americans working is good news for the bulls on Wall Street. In fact, the recent strength of US stock markets has pushed down the trailing twelve-months earnings yield, a type of yield on stocks, by nearly half a percent from the post taper-tantrum average. A move like this illustrates the conviction investors have for future earnings growth. Only greater earnings can restore stock yields back to historical norms. This type of wager on future growth might make for an unsteady market. But, contrary to belief, uncertainty gauged by US stock volatility is at a post-recession low.



Yields on benchmark treasuries continue to receive support near 2.5%. The portion of this yield that compensates investors for anticipated inflation recently rose above 2.0%. The remaining portion, which is the real risk-free reward for deferring consumption is about 0.5%. The trillion-dollar question should then begin to focus on the Federal Reserve’s balance sheet and the meager half of a percent that provides real compensation for savings. Especially since the Fed is intent on reversing open market operations, and real American output averages an annual 2.0%.

In the not so distant past, the Fed acted as a permanent buyer of treasury securities. This may change very soon. As of its latest quarterly filing, the Fed owned almost $2.5 trillion or about 13% of all outstanding public debt. Nearly half of these securities are set to mature over the next three years. Furthermore, the Fed is expected to reinvest a diminishing amount of its retiring securities. Soon, it will be left to private and foreign investors to buy an ever-increasing amount of federal debt. Will private investors accept .5% as their real reward for long-term savings? It seems unlikely.

US investment grade corporations and governments of emerging markets have taken notice of the dynamics facing interest rate markets. As well as a potential idea for legislation that would eliminate the tax deductibility of interest. Accordingly, both issuers sold record amounts of debt in January. The secondary market for corporate and emerging market debt received the news well, and investors went on to invest in these markets. Of course, this means corporate America is now more leveraged on the prospects of future earnings growth.

Wall Street now enters an important season. Corporations begin releasing results from last quarter-end. Currently, the results are stacked in favor of actual earnings per share exceeding analysts’ expectations. A good sign to support current stock market valuations.

Key fundamentals to today’s record breaking stock prices include American jobs to spur market demand; future real wage growth to support housing prices; strong earnings growth to sustain leveraged balance sheets; and the Fed’s balance sheet. If the Fed attempts to shrink its balance sheet, but the private market is not willing to absorb new treasury debt at the current low rate of real savings, interest rates could suddenly spike. 



January was another good month to be an owner of US stocks. It even paid well to own international stocks. Although, plenty of risks remain on the table, investors have gotten some confirmation that prior global deflationary woes could be on the verge of dissipating. In response, overall business and consumer confidence is rising around the globe. The recent allocation changes made to our diversified, Core Allocation strategies have already added value.  As we enter 2017, our Investment Team is optimistic regarding US markets but also realistic given current interest rate levels and global uncertainty.  Prudent diversification and discerning asset class selections are top priority for our clients, especially given this current market environment.