Another month is in the books and many economic headlines would leave you surmising that it was a good one for the stock market. In April, the initial reading of first quarter gross domestic product (GDP) came in stronger than expected at 2.3% vs. 2.0%. Economic activity in the manufacturing sector expanded in April (albeit at a slower rate), and the overall economy grew for the 108th consecutive month. U.S. earnings have substantially beaten consensus forecasts so far this season, even after earnings estimates were increased heading into the season rather than being cut as usual. The S&P 500 forward Price/Earnings ratio has fallen on a decline in prices and higher earnings and currently stands at 16.3x – a reasonable multiple and just 8% above its long-term average. Yet, the Russell 3000 Index, a measure of the broad U.S. stock market, ended the month up a mere 0.38% – leaving many investors wondering what is holding this market back.
A little digging under the market headlines sheds some light on why the strong earnings season has not been the catalyst to drive the market higher just yet. Overall, the macroeconomic backdrop has become noisier. Interest rates have risen, the dollar has risen, trade issues persist, and inflation is starting to rear its head. In April, the 10-year Treasury breached the much-watched 3% level for the first time since 2014 before ending the month hovering just below that level. This means that the equity risk premium (the additional return an asset generates above and beyond the risk-free rate) is narrower than it has been for many years. To say it another way -stocks have not become more expensive, but bonds have become cheaper. This shift will slowly lead investors evaluate the risk-to-reward tradeoff between equities and bonds more closely than they have over the last few years, which could eventually lead to investors selling equities to buy bonds.
The increase in bond yields wasn’t the only attention-gathering headline in April. Commodity and wage inflation has also led to nervousness in the markets because higher inflation expectations can drive up interest rates. Year-over-year inflation is forecast to hit 2.45% this year – up from a 2.14% low forecast last July for 2018. The big issue is how much inflation will affect margins. While it is still too early to tell, many companies are commenting on higher costs and the general negative impact such costs will have on margins, creating a scenario in which we may be approaching “peak earnings.”
These concerns have left stocks range-bound so far this year, and after two consecutive years of double-digit performance, the sideways movement of the S&P 500 Index this year has been frustrating to many. Year-to-date through the end of April, the S&P 500 Index is down -0.38% while the Barclays Aggregate Bond Index is down -2.19%. Market leadership has narrowed, with energy the only prominent sector stepping forward over the past month.
While there are some early signs in business surveys that global manufacturing and trade may have peaked, financial conditions and fiscal policy continue to lend support to risk assets. The synchronized global expansion, which shifted into higher gear last year, is likely to continue as GDP growth is expected to remain well above-trend in all major economies in 2018. We expect that fundamentals will reassert themselves over the coming months and carry equity markets higher. The S&P 500 Index has established very strong support at the 2,581 level, which is encouraging.
As for the bond side of the equation, we positioned our portfolios for rising interest rates several months ago, and most of the managers that we use are outpacing the performance of their respective benchmarks. Bond prices generally decline when interest rates rise, but it is important to remember that higher rates also mean higher yields on new bonds. So, while losses may be experienced in the short-term, over time, those higher yields should more than offset lower prices.
Overall, the current environment is not as supportive of that which gave us outsized, double-digit returns in the stock market in 2016 and 2017, nor is it supportive of that which gave us steady, positive returns in the bond market in nine of the last ten calendar years. Investors should temper their expectations accordingly and exercise patience while the market works to regain its footing. “Steady plodding brings prosperity; hasty speculation brings poverty.” -Proverbs 21:5 TLB
Thank you for your continued confidence. Please reach out to us with any questions you may have.
-Hillary Sunderland, CFA
Chief Investment Officer for Beacon Wealth Consultants, Inc.
Financial Planning and Investment Advisory Services offered through Beacon Wealth Consultants, Inc., a Registered Investment Advisor.
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All returns represent total returns for the stated period. The Bloomberg Barclays Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. The S&P 500 Index is a market capitalization weighted and unmanaged group of securities considered to be representative of the stock market in general. The Russell 3000 Index is a market capitalization weighted index that measures the performance of the largest 3,000 companies representing approximately 98% of the investable U.S. equity market. The Russell 2000 Index is a market capitalization weighted index that measures the performance of the smallest 2,000 companies in the Russell 3000 Index. The MSCI ACWI ex-US Index is a market capitalization weighted index designed to provide a broad measure of equity market performance throughout the world and is comprised of stocks from both developed and emerging markets outside of the U.S. The Bloomberg Commodity Index is designed to be a highly liquid and diversified benchmark for commodity investments.
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