Which Asset Class Will Justify Investors’ First-Half Love?
June 29, 2017 | Your Finances
How many forecasters predicted that the first six months of 2017 would witness sharply rising global equity markets alongside falling long-term interest rates? Not many, but perhaps it has been justified. Corporate profits have been strong, employment along with business and consumer confidence has been high, and inflation has remained restrained. While both bonds and stocks advanced in the first half of 2017, a second half repeat is unlikely; and markets are eagerly waiting to see which asset class will ultimately justify investors’ love.
How we got here
Post-Great Recession, all policy actions had one goal: Avoid another financial crisis. Regulations forced banks to rebuild their balance sheets and lend less, and taxes were raised to narrow government deficits. One could argue that while this helped rebuild the economy, it also slowed growth as consumers and businesses entered an unusually long period of austerity and restrained behavior.
Now, we increasingly see signs that austerity is finally ending and “animal spirits” are returning. Previously pessimistic business owners are investing to replace aged facilities and equipment, which will enhance the productivity of the millions of workers they have hired. These same companies are finding wage increases necessary to lure potential employees off the sidelines or from competing firms to fill a record number of job openings. And these wage increases will not only bolster the already confident consumer’s spending ability, but will also lead to inflationary pressures as companies raise prices to protect their margins. Add to this the potential tailwinds of tax reform, regulatory relief and government spending, and the economic picture for the second half looks promising.
So now what?
Despite this generally positive outlook for the economy, we worry that global central banks have exerted artificial upward pressure on asset prices over the past years. Our biggest fear remains the primary target for their balance sheet expansion and low interest rate policy: government bonds. The potential for a bond market hiccup is growing as the Federal Reserve unwinds its accommodative policies, while the Bank of Japan and European Central Bank inch closer to doing the same. Currently, there appears to be ample demand to meet rising bond supply—but what price will private investors pay? Will they continue accepting minimal real returns and, in some cases, outright negative nominal yields? If so, investment textbooks need to be rewritten.
The potential for volatility in the bond market, coupled with a rising U.S. economy, indicates that equities are set to continue rising, albeit at a very restrained pace. Any potential bond repricing will likely negatively impact U.S. equities given their elevated and low interest rate dependent valuation. However, we advise investors to look through any short-term correction.
Ultimately, we believe that traditional economic and market relationships will prevail. That means that this economic cycle will eventually end like all others: with the return of “animal spirits,” rising inflation and the Fed hiking rates to slow an economy without slack. It is simply taking longer than normal to get there because of the deep scars of the Great Recession. And this, in our view, means that investors’ love of stocks seems justified for the intermediate term.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life insurance with long-term care benefits) and its subsidiaries. Northwestern Mutual Investment Services, LLC (securities), subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI (fiduciary and fee-based financial planning services), subsidiary of NM, limited purpose federal savings bank.
This publication is not intended as legal or tax advice. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.
The opinions expressed are those of Northwestern Mutual as of the date stated on this publication and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. Past performance is no guarantee of future performance. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.