The second quarter of 2017 looked much like the first. All of the major asset classes we follow were up again. In the US, large-cap stocks are nearing double-digit gains for 2017 with the S&P 500 now up 9.34% for the year. Small-cap stocks continue to lag as the Russell 2000 is up 4.99% year-to-date. This relative underperformance by small caps isn’t too surprising considering the strong run small cap stocks had in the second half last year.
The big five technology companies are a major contributor to the S&P 500’s gain this year. Depending on the day, Apple, Alphabet (Google), Microsoft, Amazon, and Facebook are the five largest companies in the index by market cap and the average return of these five companies exceeds 23% in 2017. Though accounting for only 1% of the total number of companies in the S&P 500, these companies account for nearly a third of the total return of the index this year.
We have enjoyed bountiful returns investing in US stocks over the eight-plus years since the market hit its lows during the financial crisis. Depending on the metric you look at, US stocks are either fairly valued or overvalued today. That isn’t to say we are headed for a correction but in our view it does mean that US stocks aren’t likely to offer the same upside we’ve enjoyed over the last eight years.
International stocks have enjoyed a significant rebound so far in 2017, with the MSCI All Country World Index excluding US stocks (MSCI ACWI X-US) up 14.30%. Reasons for the strong returns in foreign stocks include a falling US dollar, continued stimulus from foreign central bankers, and the sweeping victory of newly-elected French President Emmanuel Macron over anti-EU candidate Marine Le Pen.
Capital Group, the manager of the American Funds, provided the chart below which illustrates their best estimation of where different countries are in the financial cycle. The chart shows how economies normally (but don’t always) move through the market cycle starting in phase one with early decline, moving on to full recession, then recovery, and finally into phase four where the expansion slows. The chart makes the case that the recent run by foreign stocks may have room to continue as most foreign economies aren’t nearly as far along in the market cycle as the US. The MSCI ACWI X-US trailed the S&P 500 by 70% from the beginning of 2008 through the end of 2016 but it is very possible we are seeing a turning point in 2017. While we would caution against trying to selectively bet on specific countries shown in the chart, we will always advocate for maintaining a globally diversified portfolio.
What happens at the end of the bond bull market?
Interest rates on treasury bonds have steadily fallen since 1981 as you can see in the chart above. This has generated good returns for bonds but has made it increasingly hard for investors to earn meaningful income from bond investments. With quantitative easing and a record-low Federal Funds Rate, the Federal Reserve helped push interest rates to new lows in the past decade. When the Fed began signaling it was time to initiate rate increases, we began hearing more and more about the coming end of the three-and-a-half-decade bull market for bonds. If we truly are at the end, however, it doesn’t mean rates will shoot higher and bond prices will start falling.
Case in point, the Fed has now raised the Fed Funds rate three times since last December and something unexpected has happened—the 10- year Treasury yield has actually fallen. What determines where interest rates will go? The answer is old-school economics—supply and demand.
Even though the US government has issued debt at record levels since 2008, there has been no shortage of buyers. The Federal Reserve has led the way as the largest single buyer of US Treasuries. During the three Quantitative Easing Programs from 2008 to 2014, the Fed went out and bought as much as $85 billion worth of bonds each month with money it didn’t have. Over this time, the Fed added nearly $2 trillion worth of Treasuries to its balance sheet.
In addition to the Fed, government agencies from all over the world have been major buyers. Since 2008, foreign governments’ Treasury holdings nearly doubled from $3.1 trillion to $6.1 trillion in April. This has primarily been driven by our trade deficit. We buy more things from China than we sell to them. The People’s Bank of China facilitates the trade imbalance by printing new Chinese Yuan to exchange for all of the US dollars flowing into the country. They have been more than happy to do so to help keep the Yuan weak and Chinese goods competitive. As a result, the Chinese government has built up over $1 trillion worth of US dollar holdings. For the most part, they have taken these dollars and bought US Treasuries.
From the end of 2008 through April 2017, 55% of the debt created by the US Treasury has ended up in the accounts of the Federal Reserve and foreign governments. The rest has been bought by individuals and institutions. Not to be forgotten, the aging US population plays a big part as well as Baby Boomers reaching retirement age need to shift some of their savings out of stocks into more stable investments like bonds.
What happens from here is hard to say but it’s difficult to see a major change coming that will push rates back to where they were 20 years ago. The Fed just announced a plan that may start later this year to let its balance sheet start shrinking by as much as $10 billion per month as bonds mature. Anything above that will be reinvested into more bonds. It will take a long time for that to make much of a dent considering the Fed’s total balance sheet is currently sitting at about $4 trillion.
There is definitely room for rates to rise but thus far indications are that this will likely happen slowly. As shown in the chart to the left, this is already the slowest pace the Fed has raised rates at any point dating back to 1976. If rates do rise slowly, bonds can still provide a positive return. In sum, given the continued slow-to-moderate pace of global growth, the absence of significant inflationary pressures, and the slow pace of central bank tightening, we think we are unlikely to see a major spike in rates that would prove damaging to bond portfolios. Regardless of what happens, the downside risk of bonds is far less than the downside risk of stocks. Bonds will continue to improve portfolio diversification while offering always-important capital protection.