Equities were seemingly caught off balance with the Fed’s ‘surprise hawkish shift’. From mine – there was very little surprising about it – you only needed to look at the data. However, what I was more interested in was how Powell would explain why they were cutting rates. As it turns out he struggled – leading to a small sell off in stocks. The irony was Powell did a better job of explaining why rates should not be lowered (which is obviously at odds with their decision to cut).
"Interest Rates / Bonds"
Inflation x Rates = Uncertainty
The stock market could not be more optimistic. And perhaps not since the dot.com bubble of 1999 – have investors been so sure of the future. Excited by a business friendly government coming to power; lower inflation; consumers continuing to spend – what’s not to like? I can think of one thing…. valuations. If buying stocks today – you’re paying through the nose. And for me – that increases your risk.
The Bond Vigilantes Strike Back
Several weeks ago I suggested investors consider reducing their exposure to 10-year treasuries. At the time, the world’s most important debt security was yielding around 3.80%. They would continue to fall to a near-term low of 3.60%. In this case, the timing was good as these yields have rallied some 60 bps in turn crushing bond prices. For example, EDV and TLT have dropped more than 10%. So why are 10-year yields rising in the face of Fed cuts? There’s a good reason: term premium. Bond owners demand a premium if owning the debt of a fiscally irresponsible government. And this has major implications for investors…
The Fiscal Tailwinds Helping Stocks
Will fewer rate cuts dampen the enthusiasm for stocks? It certainly hasn’t to this point. And could higher bond yields impact stock valuations? So far the market is not bothered. These (and other) questions need to be weighed carefully with the S&P 500 trading ~21.5x forward earnings. And whilst the multiple is heavily skewed by the ‘Mag 7’ – 21.5x is far from cheap. What’s more, from a historical perspective, paying a multiple above 20x offers investors a very low risk premium (e.g., with the risk free rate above 4.0%). But wait… what’s to say stocks cannot rise further? We’ll explore why they can…
For a full list of posts from 2017…