Stocks continued to move higher in November, with the S&P 500 returning just over 3% for the month. Healthy economic data and optimism over tax reform helped drive these gains. A flattening yield curve, however, has sparked some concerns about the health of the domestic economy. While we agree that this indicator bears close watching, in our view the weight of evidence suggests that economic conditions remain favorable for capital markets.
Economic data continued to surprise to the upside in recent weeks. Labor market conditions appear healthy with the unemployment rate at its lowest level since 2000, and the job openings rate at a cyclical high. Perhaps unsurprisingly given this backdrop, consumer confidence remains strong, as evidenced by the most recent Conference Board survey, which came in at a new high for the current expansion. This confidence may also be translating into increased spending, as the holiday shopping season looks to have gotten off to a strong start. Retailers generated record sales volumes over Thanksgiving and Black Friday, with growth coming in 18% ahead of the prior year’s level. Economists are projecting that overall holiday sales will grow by 4%, a forecast which we view as quite achievable.
A significant factor shaping our optimistic outlook has been the strengthening global economic environment. Europe has played a key role here, as economic activity has picked up meaningfully this year after having lagged consistently in the years following the financial crisis. A survey of purchasing managers in the region recently came in at the best level in 6.5 years, and the EU took its growth projection for 2017 up to 2.2%, from 1.7% previously.
The flattening yield curve has garnered much investor attention after having hit a multi-year low of just under 60 basis points during November. Curve flattening is typically seen during periods where the Fed is hiking interest rates, as is the case now. With Japanese and German government bonds currently offering minimal yields, global investors are likely shifting money into US Treasuries, which appear attractive on a relative basis. This buying tends to depress Treasury yields, and also flattens the curve.
We are not overly concerned that the yield curve is signaling weak economic conditions ahead. However, another factor at play which is a bit more concerning is the persistently low level of inflation. It is unusual for this to coincide with accelerating economic growth. Should inflation remain low, or fall even further, it would likely result in a further flattening of the yield curve, and call into question the durability of recent economic strength. In addition, should the Fed continue on its current path of rate hikes in the absence of inflation, this could increase the risks of a policy mistake and create unintended headwinds for the economy.
Significant strides have been made in regards to tax reform in recent weeks. The Senate recently passed its version of the bill, which now must be reconciled with the House’s draft. While there is still much to be done, we believe the odds of passage are meaningfully higher today than they were just a few weeks ago. We do caution, however, that the reconciliation process will likely result in a less comprehensive bill which may blunt its economic impact. Still, even a watered down version of the bill has the potential to boost economic activity and corporate profits. We are therefore encouraged by the progress being made here and continue to believe that successful passage should be supportive of equities.
Our view is that economic and policy conditions continue to be favorable for stocks. GDP growth has outperformed expectations, both domestically and abroad. This has helped to strengthen the US corporate sector, which has posted healthy profits every quarter this year. This strength is coinciding with financial conditions which remain very loose despite the Fed having begun to normalize policy. In this regard, we note that both the Federal Reserve Bank of Chicago and Goldman Sachs financial conditions indices are near multi-year lows (lower scores indicate easier conditions). These indicators measure the ease with which credit flows throughout the economy, and are based on factors including stock volatility, borrowing costs, and currency movements. Tax reform could add more fuel to today’s easy financial conditions, as overseas cash is brought back by multinational firms and utilized for capital expenditures, M&A, dividends, and share repurchase activity. We continue to hold the view that strong profits and easy financial conditions should bode well for the market.
In our view, perhaps the greatest risk to stocks currently is if the Fed continues to hike rates while the recent spate of economic outperformance proves to be an aberration. If the flattening yield curve does in fact portend weaker times ahead, and the Fed continues to tighten, markets would not react well. We do not expect this scenario, but we do have to be cognizant of this risk while constructing our portfolios. We therefore continue to maintain our barbell approach, allocating a segment of the portfolio to companies that we expect to outperform in a strong economic environment, while making sure to maintain exposure to more defensive holdings and natural hedges should the macro backdrop weaken.
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