With long Treasury bond yield continuing to press higher, the 3-month to 10-year yield curve, which has been inverted for a few months, is very close to uninverting, perhaps even before the Federal Reserve lowers the Fed Funds rate by at least 25 basis points at the end of the month.
The changing shape of the yield curve reflects (1) confidence that the Fed and other central banks will be easing monetary policy in the months ahead, and (2) that economic growth will reaccelerate in part due to easing financial conditions.
For stocks this is a potential double-edged sword. The move back up in rates for 10-year Treasuries will push P/e ratios a bit lower. However, if confidence in better earnings ahead improves, the offset would be enough to let stocks continue their run to record highs. Obviously, earnings season, which begins this morning as Citigroup reports results, holds the key. Management commentary regarding the outlook for the balance of the year will be key to sustaining the market’s current optimistic mood.
Some suggest that the market’s multiple could actually rise along with improved confidence despite any possible further rally in Treasury yields. In the short run, emotion can trump rational behavior and, thus, anything is possible. But as we have learned several times over the past couple of years, excessive optimism unsupported by reality leads to quick short-term declines. I am not predicting that. But I think if stocks march much further into new high ground without accompanying fundamental support, the odds of a mild but sharp correction increase.
With those technical thoughts said, there are good reasons to be optimistic about the outlook for corporate earnings. First, consumers are still in a good mood and spending money. High debt loads and rising credit card debt do pinch some buyers, notably among millennials, but the data shows no serious threat to a solid spending environment. Today and tomorrow is Amazon Prime Day(s) and I have little doubt that the numbers will show record spending, for instance. Second, unemployment claims remain near record lows. As long as people have jobs and they are secure in their employment, there is no good reason to expect spending growth to slow in any meaningful way. Third, the recent drop in rates has begun to filter through to the housing market. Demand is solid. Indeed, what may be holding back home sales is a dearth of quality supply. That have allowed both rents and sale prices to stay firm. While that is good for sellers, strong prices do keep some potential buyers out of the market. Finally, the dollar, year-over-year, is about flat and, therefore, no longer an impediment to higher earnings. Until now, the strong dollar has caused foreign earnings to appear lower when translated back into dollars. That headwind disappears in the second half of 2019. Lower Fed Funds rates could actually help to push the dollar slightly lower.
One group that could be particular beneficiaries of any move to economic acceleration and higher rates is the financial sector. Banks struggle when rates fall, the yield curve flattens, and demand for loans wanes. But loan demand has remained solid throughout the year. If investors sense a better net interest margin ahead, banks could respond. Investment banks would also gain as brokers earn more money on idle cash balances and margin loans. Credit card companies would also earn higher rates. If the economy remains solid, consumer credit losses would remain contained.
The first half of 2019 was quite strong. Part of the gains, of course, were a recovery of 2018 fourth quarter losses. But still, with stocks now at record highs, there has been real forward progress. Valuations are stretched, the one significant negative, but if earnings start to reaccelerate, that headwind may slow the pace of further progress but shouldn’t stop it altogether.
While financials may regain some solid footing, in mature bull markets, leadership rarely changes suddenly. That means, even with valuations high, that technology, communication services and consumer discretionary names should remain leaders. Among other groups, companies that can match GDP growth on the top line and generate enough free cash to sustain and grow both dividends and share repurchases should continue to do well.
Today, Forest Whitaker is 58. Arianna Huffington is 69.
James M. Meyer, CFA 610-260-2220
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