A Complete Reset of Expectations
The conclusion of our April commentary outlined our belief in a disconnect among expectations for economic growth, corporate earnings, and interest rate policy set by the Fed. The second quarter helped define a lower growth scenario as the base case moving forward with markets adjusting to incorporate this outlook during the quarter. Discussion and concerns for further interest rate increases by the Fed are now in the rear view mirror with upcoming rate cuts now expected by the market. The shift from the Fed increasing rates in December 2018 – to being on “pause” in January – and now expected rate cuts during their upcoming July meeting shows how quickly data and market expectations can change. So where do we go from here?
The sudden change to lower interest rate expectations caused short, medium, and long-term interest rates to decline substantially during the quarter leading to strong returns for bonds. With this shift, investors are no longer discussing a “bear market for bonds” or seeing bonds as a fool’s investment. Due to the increase in bond prices that accompanied the recent decrease in interest rates, bond returns are now expected to be lower moving forward because yields are lower. Credit spreads (the difference in yield between risky bonds and US Treasuries) are near historical low levels meaning investors are not receiving much compensation for taking additional risk in lower quality bonds. In our view, now is not the time to reach for yield in riskier bonds. If credit spreads increase we may reassess this outlook. However, at this time, we continue to advocate focusing on high quality bonds that will provide protection and perform well if interest rates decline further. That being said, we expect bond returns to be low for the foreseeable future.
Stocks experienced a net positive return during the second quarter, but were choppy with a peak-to-trough decline of around 7% for the S&P 500 during the quarter. With five year US Treasuries now paying around 1.8% annually, many investors are looking to stock dividends as a viable alternative to bond coupons with the S&P 500 also currently yielding around 1.8% annually.
We believe corporate profits are now the key to this market. If they remain stable, stocks could perform well as investors see a low interest rate environment as favorable and view stocks as the best vehicle for returns. Alternatively, if corporate profits begin to decline and economic growth expectations turn negative, stock valuations will appear high and the market may reprice to incorporate this new outlook. At the end of the day, stocks are near all-time highs and without a significant change in growth expectations or increased likelihood of a recession, we are cautiously optimistic for positive stock returns.