Heading into 2016, three themes dominated market sentiment.
Investors, collectively, had expected the first few months of the year would bring:
- An appreciating U.S. dollar that would continue to dominate most major currencies
- Further declines in oil prices, as bids for an oversupply of crude languished lower still
- Continued weakness in emerging markets, with the world's developing economy debt doing badly and its equity even worse
Recalling the historical tendency of the U.S. dollar to fade, rather than strengthen, following the first interest-rate hike of a monetary tightening cycle, we were wary of these consensus views. Rightfully so, as it turns out. From the beginning of the year through the end of August, the U.S. Dollar Index fell from 99 to 96 points, oil prices rebounded from $37 to $45 per barrel, and emerging-market indexes across the capital structure posted double-digit percentage gains.1
Now we see two more consensus themes developing that, in our view, merit a measure of skepticism: the notion that bonds will be fantastic forever and that U.S. stocks are on their last legs.
Many investors behave as though bonds will be fantastic forever
After peaking in the early 1980s, interest rates, or yields, spent the subsequent decades declining, which pushed up bond prices, as they move inversely with yields. With so many different bond markets faring so well for so long, disappointed debt investors are difficult to find these days. Over the course of the last year alone, mutual fund shareholders directed more money to taxable bond funds than to any other category Morningstar tracks, with municipal bond funds representing the runner-up.2 On the surface, fixed-income assets might seem to merit this extreme optimism: Most major central banks continue to pump liquidity into the global financial system, and persistently slow economic growth seems to have tamed inflation risks for the time being. Moreover, with cash continuing to yield next to nothing, savers seeking nonzero returns have no choice but to allocate their reserves elsewhere—a dynamic that's helped maintain the bond bid for years.
However, today's yields are among the lowest in recorded history, and it's unrealistic to expect them to continue falling indefinitely. Certain sovereign debt issues of Japan and several European countries already trade with yields less than zero, an unprecedented, and unsustainable, situation. Meanwhile, in the United States, wages are up, unemployment is down, and core consumer inflation is over 2%, as the U.S. Federal Reserve contemplates its second interest-rate hike of the tightening cycle in progress.3 Given the diversification benefits, it would be unwise to abandon bonds altogether, but we would encourage investors to keep their expectations in check. Given today's anemic yields, fixed-income assets are unlikely to generate the same generous results that the average bondholder has realized in recent decades.
As an extended run-up continues, many investors view U.S. stocks with anxiety
Over the last year, while billions of dollars were flowing into bond funds, many of those same dollars were flowing out of U.S. equity funds. Six quarters of lower corporate earnings, coupled with more than two years of generally sideways trending price action (punctuated with some pullbacks and market highs along the way), seem to have spooked skittish investors out of stocks and into bonds.
As the U.S. expansion continues to mature, this may be the most hated bull market of all time. Paradoxically, that makes us optimistic about domestic stocks. Economic weakness throughout the rest of the world has placed the United States in a position of relative strength, buoyed by resilient consumer spending, in turn supported by low mortgage rates and low oil prices. Yes, U.S. stock valuations are relatively high, but we think they're likely to remain high as long as investors favor equity assets with some measure of insulation against uncertainties in Europe and elsewhere. Remaining cognizant of the risks associated with higher valuations, we persist in our relatively positive view of U.S. equities over a three- to five-year horizon. By capitalization, the United States represents the largest of the global stock markets, and the country's level of economic and even political stability is higher than anywhere else in the world. It's true that valuations of the U.S. market are relatively higher, too, but given the scarcity of economic growth around the world, we wouldn't be surprised to see those valuations remain on the high side of normal for an extended period of time. As the U.S. expansion continues to mature, domestic equity investors may want to think twice before giving up on this bull market and plowing all the proceeds into bonds.
1 Market Watch, U.S. Energy Information Administration, 2016.
2 “Morningstar Direct Asset Flows Commentary: United States,” Morningstar, 8/12/16. For the 12 months ended 7/31/16.
3 Bureau of Labor Statistics, U.S. Department of Labor, 2016.