Data Source: Bloomberg
Technology (and "momentum") are propelling this year’s advance in the U.S. markets, leaving other sectors (and styles) well far behind. For the month, U.S. technology advanced 7.8% vs. 2.9% for the S&P 500 Index and is up 37.2% so far in 2017 vs. 16.9% for the S&P (Exhibit 1a and 1b). Of course, this leadership is not happening in a vacuum as investors have been cheering the latest third quarter earnings results. Technology companies have reported, in aggregate, 14.8% earnings growth year-over-year based on reported 3Q earnings through 10/27/2017, according to Factset Earnings Insight. It’s not just the FAANG stocks that are publishing strong earnings but also the "belts-and-suspenders" tech companies such as semiconductors/equipment makers which were the “largest contributor to earnings growth in the sector.” Finally, many large cap technology stocks with overseas earnings would likely benefit from a one-time tax on repatriated earnings as part of tax legislation.
Exhibits 1a and 1b – Technology Leads All U.S. Sectors in 2017
As with the leadership of technology, "momentum" style of investing is dominating all the other major factors (Exhibits 2a and 2b) year-to-date 2017. And as has been the case for the last couple of quarters, "value" and "dividend yield" started the fourth quarter on a weak note. Perhaps, we’ll see a late quarter-end rally for "value" similar to what has happened the last two quarters. For now, this remains firmly a growth rally where valuation has given way to earnings growth expectations and market dominance.
Exhibits 2a and 2b – Momentum Dominating Other Factors within the U.S.
As we highlighted in our mid-October blog article “The Changing Landscape for Traditional Active Management,” this widening gap between the "haves" (technology/momentum) and everything else can mostly explain the fortunes (or misfortunes) of actively managed strategies versus their cap-weighted benchmarks. This narrow contribution to market leadership could be interpreted as one cautionary sign, namely that new market advances are being driven by a handful of names (or in technical terms, equity markets are experiencing poor breadth). Given how extended the current business cycle is versus prior cycles, investors may be rightly concerned about the breadth and quality of further market advances that lack broad participation from non-growth oriented market segments.
Strong Sentiment Also Propels Global Markets
The overseas growth picture improves with each month with manufacturing sentiment strong across major regions (Exhibit 3).
Exhibit 3 – Global Manufacturing Sentiment (PMIs) Show Synchronous Strength
Despite the strong populist outcomes in the recent German and Austrian elections, the overall geopolitical landscape has provided a more stable backdrop. Japan’s Prime Minister Shinzo Abe and his Liberal Democratic Party dominated parliamentary elections held on 10/21/2017, emerging with a supermajority that could result in a revision of Article 9 in the post WWII constitution allowing for a military buildup in response to heightened threats from North Korea. Japan is enjoying a resurgence in growth sentiment (Exhibit 4) as well which is helping its stock market (a weakening yen is also helping).
Exhibit 4 – Rising Business Sentiment in the Land of the Rising Sun
Japan’s electoral outcome helped push its market into the lead over other major regions for October (Exhibit 5) followed by pan-Asia which has largely benefited from the U.S. tech rally. Europe lagged in the month as the region continues to wrestle with Brexit negotiation impasses, Catalonia threatening secession from Spain, and a decidedly populist shift in the Austrian elections following the German elections. China is starting to exhibit some issues in its lending markets as the shadow banking system, which has grown to more than $4 trillion as of September, has had to wrestle with less funds coming from China’s banking sector resulting in the sale of Chinese government bonds by non-bank entities. A breakdown in the wholesale lending channel could reverberate throughout the broader financial system.
Exhibit 5 – Japan and Pan-Asia Lead Major Regions in October
And despite the elections, Brexit impasse and Catalonia, business sentiment in Germany has reached a cycle high (Exhibit 6). The euro weakened against the U.S. dollar following the European Central Bank’s announcement that they will slow down the pace of bond purchases but extended the window on those purchases further out. The markets responded positively to this news as the ECB will likely take its time to unwind emergency monetary measures that were taken following the 2011-12 sovereign debt crisis.
Exhibit 6 – German Business Sentiment Hits a Cycle High
Credit Continues to Lead within Fixed Income
Investors in corporate credits continue to enjoy higher total returns due to credit spread tightening (Exhibit 7). According to Moody’s, the US speculative-grade default rate dropped to 3.3% at the end of the third quarter and is projecting a default rate of 2.3%. Whether a 3.7% option-adjusted spread above U.S. Treasuries is enough to compensate investors for default risk remains to be seen, but the chase for risky credit could be considered rational when seen in the context of the strong advance in global equity markets.
Exhibit 7 – Credit Spreads Tighten to 3-Year Lows
The U.S. Treasury market is pricing in a less sanguine economic view based on the flattening of the 2-10 year term structure and that forward inflation expectations remain below 2% (Exhibit 8). Some observers argue that it’s difficult to discern what the Treasury markets are pricing in given the intervention of Central Bank purchases as part of their quantitative easing measures.
Exhibit 8 – A Flattening Term Structure and Low Inflation Expectations Imply Federal Reserve Tightening is Close to Coming to an End
In addition, U.S. Treasuries do not move in a vacuum and are influenced by global inflationary conditions as German and Japan bond yields help anchor U.S. Treasury Yields (Exhibit 9).
Exhibit 9 – Inflation Would Need to Pick Up Globally For an Extended Rise in Bond Yields
Regardless, the main takeaway from an asset allocation perspective is that investors are probably better compensated for taking on "equity" risks within their equity allocation rather than their fixed income allocation given how narrow credit spreads have compressed.
The U.S. Needs a Productivity Boost to Extend the Cycle
One of the goals of the Republican-led push for tax reform is to make the U.S. tax regime more competitive with the rest of the world, or at least catch up with global trends on corporate taxation. A key objective would be to stop multinationals from fleeing to lower tax havens and parking global earnings at foreign offices, but a primary goal of U.S. tax reform should be to incentivize business to invest more in capital equipment and research and development in order to improve productivity which had slumped in the second half of 2016 but has since recovered a bit. Although this chart from the Bureau of Labor Statistics is only updated through 3Q2016, it shows how the magnitude of how much economic output has lagged in the current cycle versus historical averages (Exhibit 10).
Exhibit 10 – US Business Sector Output Lags Historical Output
Financial conditions remain loose even as the Fed has tightened. There are not many policy tools left to extend the current cycle, but a productivity boost could enable this cycle to last longer without inducing any late cycle inflation that would prompt the Fed to aggressively tighten financial conditions.
As global equity markets advance, risk premiums have been squeezed tighter. According to Bloomberg consensus estimates, the S&P 500 trades at 19.4x multiple to next 12-months earnings and 21.6x trailing 12-months earnings. A 19.4x multiple translates to 5.15% earnings yield which is less than a 3% spread to 10-year Treasury Yields. Markets can continue to advance on earnings growth, but a productivity bump would likely be needed to help extend valuations to higher levels.
A Quick Word on Cryptocurrency
With Bitcoin surpassing $7,000 at the time of this writing, we’d be remiss if we didn’t include a blurb on cryptocurrencies. According to engadget.com (hat tip to Grant’s Interest Rate Observer), Icelandic signer Bjork will include free cryptocurrency with her upcoming album. Supposedly, holders of "audiocoins" (designed by Blockpool) will have a chance to earn “crypto rewards” as well as the chance to interact with Bjork online and attend her concerts, but “it’s not clear yet exactly how that will work. According to the website coinmarketcap.com (again, thanks to Grant’s), there are now 1,255 cryptocurrencies in circulation, up from 865 in early September (yes, as in the September two months ago). I have to confess that even being a fan of the Sugarcubes is not enough to entice me to invest in cryptocurrencies (and yes, that is a personal view of mine and not necessarily that of 3D Asset Management).
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.