Stocks rose modestly during the third quarter, as markets proved to be resilient despite mixed economic data, a run up in sovereign yields, and concerns about the European banking sector. In our view, however, equity valuations appear somewhat extended given elevated levels of political and economic uncertainty. We therefore continue to believe that a cautious investment approach is the most prudent strategy in the current environment.
Central banks again dominated financial headlines this quarter. The Bank of Japan (BOJ) surprised investors by adopting new strategic initiatives whereby it will target long-term yield levels as well as the shape of the yield curve. The central bank will attempt to keep 10-year Japanese government bonds at prices consistent with approximately 0% rates, while simultaneously attempting to steepen the yield curve. We find this interesting for a number of reasons. The extraordinary monetary policies enacted by central banks in recent years have resulted in certain unintended consequences, including a yield environment which has hurt the profitability of the financial sector. By incorporating a targeted steepening of the yield curve into its objectives, the BOJ is making a concerted attempt to reinvigorate this key sector of the economy. In this regard it is not surprising that Japanese financial stocks soared 6% on the day of the announcement.
We also see these moves as an acknowledgment that the BOJ’s past easing initiatives have been ineffective, as inflation has fallen short of the bank’s target, and the yen has continued to strengthen. In our view, monetary stimulus is reaching the limits of its effectiveness in boosting economic activity, as evidenced by lackluster growth rates in much of the world despite central bank policies which in aggregate are highly accommodative. Perhaps this shift in the BOJ’s strategy is an implicit acknowledgment of this view, as it is a move away from a set amount of asset purchases per month, and the targeting of yield levels opens the door to a potential reduction in bond purchases should markets push yields meaningfully below 0%.
In the U.S., the Federal Reserve held its most recent policy meeting in September. In its statement, the committee noted that the case for a near-term rate hike has strengthened. Three committee members dissented, as they felt that an immediate increase was justified. We take this as further evidence that the Fed is likely to move in the coming months. However, we believe that most investors, ourselves included, were already anticipating one rate increase by the end of the year, and were therefore more interested in the Fed’s longer-term views. Here the message was dovish, as committee members took down their projections for the number of rate hikes next year and also lowered their long-term growth expectations from 2% to 1.8%. This latter reduction was in part due to the Fed’s belief that productivity growth will remain weak for an extended period.
Beyond 2016, the path towards a normalization of interest rates appears quite opaque in our view, as we question whether the economic environment is strong enough to warrant a faster pace of rate increases. GDP growth has been lackluster at approximately 1% over the last several quarters, and while activity looks to have picked up during the third quarter, estimates have come down meaningfully in recent weeks. Moreover, while consumption has by and large been healthy, the rest of the economy in aggregate remains weak in our view.
Sovereign bond yields were another focal point for investors during the quarter. Yields moved markedly higher during August and into the early part of September. Central banks likely played a role, in our view, as investor anticipation built for a Fed rate hike in the U.S., and the European Central Bank elected not to take any new stimulative measures at its most recent meeting. Expectations for new fiscal initiatives in many developed countries may also have helped to drive yields higher.
There are many implications of higher borrowing costs for governments, but for equity investors perhaps the most immediate risk is to valuation multiples. All else being equal, higher yields tend to compress multiples (such as the price-to-earnings ratio), which can result in lower stock prices. While government bond yields certainly have plenty of room to move higher by historic standards, we do not see this as a likely scenario for the near-term. In our view, economic activity both in the U.S. and in the majority of major international markets remains too uneven to justify such a move. Inflation too remains at low levels across much of the developed world, another factor which argues against meaningfully higher bond yields.
We continue to hold a somewhat cautious view on the market. A key concern of ours is the uninspiring economic growth which has ensued over the past several quarters. We continue to believe that the uncertain political environment leading up to the election may be negatively impacting business activity. In this regard, we note that the paring down of inventories has been a drag on growth for the past five quarters, an unusually long streak particularly during a period of economic expansion. We are also concerned that corporations may have baked too much of a second half economic rebound into their earnings guidance. While GDP appears to have accelerated during the third quarter, we caution that estimates have been dropping considerably in response to lackluster economic data. The Atlanta Fed’s projection, for example, has fallen from approximately 3.5% to 2% over the last two months. So while we still expect an uptick in GDP growth, we fear that it may not be sufficient to enable companies to generate strong enough earnings to continue to propel stocks higher.
We are not outright bearish on the economy, and do note that consumption has been a source of strength. While August retail sales did come in below consensus expectations, they had been quite strong for most of the spring and summer. Moreover, recent measures of consumer sentiment have come in at robust levels. However, most other sectors of the economy, in our view, have been weak. Purchasing managers’ indices (PMI) for both the manufacturing and service sectors fell in August. The former dropped below 50, indicating a contraction in the manufacturing space, while the reading for the service sector hit its lowest level since 2010.
Still, there are reasons for optimism. China’s economic data has improved in recent months, and we expect that this will benefit U.S. companies with exposure there. The UK has also been resilient in the aftermath of the ‘Brexit’ vote, as evidenced by a string of stronger than expected economic data reported over the past month. In our view, the country has gotten a strong lift from the pound’s considerable depreciation. Domestically in the energy sector we have seen a rebound in the number of rigs in operation, which should give a boost to activity in the sector. Should these factors, along with a healthy consumer, enable the U.S. to generate above-consensus GDP growth, companies may have an easier time growing earnings than we currently envision.
Finally, much has been written in the financial press about Deutsche Bank’s mortgage-backed securities settlement negotiation, and its potential impact on the company. We are not overly concerned about this issue, as in our view the bank has sufficient levels of liquidity and capital to weather this storm. While the penalties may weigh heavily on the bank’s profitability, we do not view this as a solvency issue. For this reason, we view the matter as idiosyncratic in nature, and not one that poses any meaningful systematic risk. That said, the episode highlights the fragility of many large banks across Europe, which could pose a future risk for capital markets, especially as it interplays with the rise of populist and euroskeptic movements into an election cycle.
To conclude, there are positive fundamental forces currently at play, and certain risk factors have diminished. On the other hand, there remains a healthy list of concerns facing investors, including the pace of Fed rate hikes, geopolitical frictions, and the upcoming presidential election in the U.S. and the ramifications therefrom. Overall, we view the path ahead for both corporate earnings and the economy as sufficiently uncertain to give us pause, particularly with valuations somewhat extended and stock prices just a stone’s throw away from all-time highs.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.