A market milestone is reached this week - 3% 10-year treasury
Markets are now concerned that our new Fed chairman, Jerome Powell, will prove to be a “hawk” and aggressively raise interest rates. Many financial experts point to the flattening yield curve as a leading indicator of a looming recession or "soft patch" in 2019. The economy is getting unprecedented fiscal stimulus from the Tax Cut and Jobs Act of 2017 at a time when the Fed is raising rates, and the federal debt has begun spiraling upward.
*For a deeper explanation of the "yield curve tell," check out this piece by me posted in February 2017.
Contrary to Wall Street’s consensus view, I think the Fed will raise rates only two times this year. While inflation, wage growth, and the economy show signs of picking up, it’s not overheating, allowing the Fed to gradually raise rates this year and in 2019.
Additionally, both the European Central Bank and the Bank of Japan are not planning rate hikes, and their buying of our treasuries along with foreign capital seeking better returns could put a lid on further rate increases for the balance of the year.
My view is that the 10-year Treasury yield could rise to 3.5% within a year as the Fed follows a steady and slow path of tightening.
At Cambridge Wealth Management, we continue to favor a short-duration laddering strategy of investment-grade corporate bonds and CDs on the short-end. Investors are finally getting paid to hold CDs as 6-month paper approaches 2%. And select 2023 BBB-rated financial paper is close to yielding 4% again.
Note on Municipal bonds: The new $10,000 limits for deducting state tax against one’s Federal tax makes municipal bonds even more attractive to wealthy individuals living in high-tax states like California, Connecticut, New York, New Jersey, and Maryland. The two categories that look are appealing within the muni space are the top ten U.S. ports and airports.
The Bottom Line:
So far this earnings season, a lower tax rate for corporate America is more than offsetting any impact of higher wages and other rising costs, resulting in a record-level net profit margin. But given the recent breakdown in leadership from the FAANG group, concerns over mistakes by a new Fed Chairman, and ever-changing, worrisome tweets from our president, the market has a reason for pause as it sells the good news and reevaluates risk premia. However, I remain reasonably optimistic on the market with a year-end target of 2850 for S&P 500.
I continue to overweight small cap relative to its global allocation benchmark in our model portfolios. Small caps have less currency, interest rate, and tariff risks than large-cap multinationals and should perform well in the current market environment. In the tactical equity sleeve, I am fully invested in four sectors ranging from basic materials to information technology - mid-cycle plays.
From a technical standpoint, the U.S. market is showing signs of support at S&P 500 2600 and further downside risk seems muted. And if the Trump administration is successful in negotiating better trade deals with China and restructuring the terrible NAFTA deal, I believe the best days lie ahead for corporate America and it's labor force. A cautionary word: As I stated in the Q1 Market Update, current investigations of President Trump may "turn out to be a more significant market risk in 2018 than extended valuations, Fed hikes, trade wars, Iran, or North Korea."
From a valuation viewpoint, the market appears fairly priced and trading at about a price-to-earnings (PE) multiple of 24. A PE of 24 may be seen as pricey compared to historical averages and the Cape-Shiller PE median of 16.7, but I think it’s justified by the current era of very low-interest rates and sub-par GDP growth over the past decade. Year to date, interest rates have risen, and as a result the valuation of stocks, as measured by PE ratios, has dropped. If one calculates PE with the FED Model PE Ratio, a 10-year treasury yield of 3% equates to a fair value ratio of 33 (1.0/.03), which is above where the market PE sits now.
*Check out historical PE ratios here.
Lastly, one thing I’ve learned over the years is that the current level of PE ratios, whether trailing 12 months (TTM) or Shiller, has been shown to be a poor guide to market timing and asset allocation shifts. Many investors missed out on the recent market recovery by applying such a methodology. However, buying and holding a diversified portfolio aligned with your personal risk tolerance and values is the best defense against uncertain markets.
Should you have any questions or concerns, please feel free to contact Cambridge Wealth Management.
Sources: Wall Street Journal Online; Bloomberg News; Investor’s Business Daily; Forbes.com; CNBC News; Seeking Alpha: Reuters News; New York Times.
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