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Categorized | Capital Markets

US stocks and bonds enjoy strong gains


Posted on June 30, 2014

Investors can be forgiven for thinking they have the midas touch at the halfway stage of the year. Solid returns across many asset classes beg the question for the second half: how much longer can equity, commodity and bond prices keep rising in unison?

Holders of long-term bonds are sitting on double digit gains, commodities are up some 7.1 per cent, while US equities have recorded their sixth straight quarterly gain – a run not seen since the boom era of 1998 – against a backdrop of slumbering market volatility.

Some, such as the Bank for International Settlements, warn financial markets have become “euphoric” thanks to massive support from central banks, storing up big trouble ahead for overvalued asset prices.

Notably, this year’s broad-based performance has occurred against a backdrop of political instability in Ukraine and the Middle East along with deeply disappointing US first quarter economic activity.

For now, the rally in both US bond and equity prices is being sustained by investors taking diverging views on the prospects for the economy. Equity bulls see a strong second-half recovery that boosts company revenues, while the Treasury bond market is signalling sluggish growth prospects which is seen as preventing the Federal Reserve from raising interest rates towards its late 2015 and 2016 forecasts.

    Macro uncertainty only makes the job for portfolio managers that much harder as they assess what has worked so far this year and look to tweak their holdings for the rest of 2014. Particularly given the pronounced bull run in US equities since 2009 that has the S&P 500 sitting just shy of its recent record close of 1,962.87.

    One concern for investors is how the broad market has not experienced a major correction since the summer of 2012 and from November of that year, has remained in a strong bullish trend. Given the S&P’s year-to-date rise of 7 per cent including the reinvestment of dividends, a more defensive posture is being recommended by some investors.

    Jack Ablin, chief investment officer at Harris Private Bank, says the S&P 500 is close to achieving its 2014 target of a 7.5 per cent total return. “Upside is limited and this is not a market where I want to deploy new money.”

    He remains overweight large multinational US companies and also value stocks as these areas remain cheap relative to small-caps and stand to benefit from any rebound in the eurozone triggered by aggressive easing from the European Central Bank.

    Russ Koesterich, chief investment strategist at BlackRock, says stocks can rise, but that gains are likely to be muted and he worries about US valuations and low volatility.

    FactSet estimates the 12-month forward price to earnings ratio is 15.6 times, up from 15.3 times at the end of March and higher than the 10-year average of 13.8 times.

    A defining trend of the past few months has been historically low volatility across major markets. In June, the CBOE Vix volatility index, known as Wall Street’s “fear gauge,” fell below 11, indicating investor complacency. Heading into the back half of the year, some investors are less sanguine.

    “The takeaway is don’t get used to this low volatility period,” says Raymond Nolte, chief investment officer at SkyBridge Capital. “Geopolitical risk, US midterm elections and the completion of the taper all have the potential to introduce volatility into the markets.”

    The takeaway is don’t get used to this low volatility period. Geopolitical risk, US midterm elections and the completion of the taper all have the potential to introduce volatility into the markets

    – Raymond Nolte, SkyBridge Capital

    Some believe the message being sent from sharply lower bond yields should ring alarm bells for equity bulls as we enter the second half of the year.

    Oliver Pursche, president of Gary Goldberg Financial Services, worries about the US economy’s trajectory and says the prospect of prolonged subpar growth presents a bigger challenge to asset managers.

    “There’s always some excuse why the economy hasn’t expanded at a faster pace. The truth is this economy hasn’t managed to grow at a 3 per cent rate in spite of the extraordinary amount of stimulus in the past five years.”

    Mr Pursche still expects the S&P 500 to test the 2000 points level by the end of the year, but “the second-quarter earnings season needs to be very strong for that to happen”.

    Cost cutting may help companies surpass profit expectations, but a missing ingredient for helping consumer spending resides in higher wages that can offset rising commodity prices.

    “At this stage of the cycle, nearly five-and-a-half years after the recession ended, there should be, or needs to be a sustainable acceleration in wage growth,” says John Brady, a managing director at RJ O’Brien.

    It explains why some are closely watching oil prices and worry that the global economy could suffer a shock that ruptures across currently sanguine markets as the summer slips into autumn.

    “The recovery globally is still fragile. The last thing you need right now is significantly higher oil prices,” says Mr Koesterich.