It may be hard to find true “undecideds” in the political arena at this point, but there are a few lively debates and plenty of position-switching in markets with ten weeks remaining in what has been a rewarding, but consensus-snubbing, year for investors. Is the month-long surge in Treasury yields a confirmation, a refutation, or a threat, to the prevailing soft-economic-landing outlook? Is the market’s attempt to front-run potential U.S. election outcomes a reliable signal of how policy might sway economics? And how should investors be thinking about future equity returns as the bull market enters its third year riding stellar multi-year performance and facing demanding valuations? What are bonds saying? The ramp in the 10-year Treasury yield from 3.6% when the Federal Reserve cut short-term rates by half a percentage point on Sept. 19 to above 4.2% last week was a jarring move that eventually got the attention of equity investors. US10Y 6M mountain U.S. 10-year Treasury, 6 months It conveys a multi-pronged message: Traders were caught betting on continued aggressive dovishness from the Fed, perhaps on further economic softness. And instead the economic data immediately began surprising to the upside, quickly forcing the Street to dial back future rate-cut expectations as market-based inflation indicators bounced from multi-year lows. One take is that the selloff in bonds is an indictment of the Fed for a panicky policy mistake by easing 50 basis points into a resilient economy with stocks at a record and credit spreads near generationally tight readings. (1 basis point equals 0.01%.) Or did the bond market simply conclude that the Fed’s commitment to lowering rates toward neutral while protecting against undue further weakening in the labor market insulates the economy from a damaging downturn? It’s probably no accident that the push higher in the 10-year yield above 4% has simply taken it back to where it sat at the end of July, immediately before a limp payroll report triggered a two-month “growth scare” for the U.S. economy that had some economists screaming that the Fed had made a mistake by waiting too long to ease. This would track with the history of the one pristine Fed-enabled soft landing of recent decades, when an initial rate cut in July 1995 immediately sent the 10-year yield rising by more than half a percentage point over the next month, before resuming its longer-term decent. And, on a more abstract level, a 4.2% 10-year yield isn’t out of line with a U.S. economy now operating at a 5.5% nominal GDP growth pace (based on current GDP tracking models and prevailing headline inflation rates). 3Fourteen Research founder Warren Pies sees the yield move as mostly about the macro improvement and indeed calls 4.2% “the low end of fair value” for the 10-year note. It also happens to be a technical level where Treasury buyers should emerge if this were just a counter-trend bond selloff. Estimates of what yield level – nominal or real – would more seriously pinch equity values tend to lie just a bit above where they are now. Trading the election noise Because moves in bond prices are a phenomenon of the world about which people often disagree, they are being wrapped into the inescapable election discourse along with just about everything else. For as much as investment commentators and market historians consistently caution that presidential elections are rarely a crucial swing factor for the broad trajectory of a business cycle or bull market, investors as a group can rarely resist fixating on the implications and trying to front-run the policy impact. Over time, most of what the market has wanted from a presidential election has been for it to be over, after which stocks have tended to do well regardless of the prevailing party. Yes, the standard “Trump trade” built to capitalize on lower taxes, less regulation and higher trade barriers has been evident in recent weeks as the betting odds have tilted sharply toward Trump despite polling averages remaining too close to call with much confidence. Leadership from banks and cyclical stocks with a rising dollar and climbing bond yields all fit with this potential outcome, at least based on a presumed “2016 rerun.” But isn’t this also what one would expect to happen with a Fed easing into a good economy and corporate earnings beating forecasts at an above-average pace, which reflects today’s observed reality? Pat Tschosik, senior portfolio manager at Ned Davis Research, notes that while recent market moves have correlated to betting-market odds of a Donald Trump victory, “it is difficult to separate market drivers like election sentiment from positive macro surprises…While Trump speculators have contributed to market optimism since early September, they are not likely the main drivers. Consider all the positive developments since early September. The Fed surprised with a bigger-than-expected 50 basis point rate cut, September payrolls were nearly 100,000 above consensus, retail sales surprised {to the upside] and economic surprises turned positive broadly.” And how to account for the fact that as much as the recent rally has some hallmarks of an anticipation of a Trump win, history says that when the Dow Industrials have been up from mid-August into election day, the incumbent political party has nearly always won, according to Leuthold Group. A more interesting question is whether the old Trump-trade playbook will even prove as useful this time around should he win, given how radically conditions today so differ from those in advance of the 2016 Trump victory. For one thing, markets had not significantly anticipated a Trump win in 2016, and indeed there was a reflex selloff on election night, which quickly reversed. Markets instantly saw that the incoming policy mix was a formula for higher nominal growth rates in what had been an expanding but underperforming economy with chronically low inflation and stop-start growth. But today’s setup is something close to the opposite of that. The CPI inflation rate in 2016 was consistently running below the Fed’s 2% target; today the Fed has spent two and a half years trying to wrestle inflation back down toward 2%. So, expansionary policies that would quicken the economy’s metabolism and produce more inflation was exactly what the market craved then – but now? As for equity-index field position, the S & P 500 in late October 2016 was trading at a level it had first reached 18 months earlier, before the nasty chop-fest if 2015-2016 set in (China devaluation, industrial recession, Brexit, Fed trying to lift rates into a so-so economy). Its forward price/earnings multiple was under 17. Right now, the S & P 500 is up 42% from 18 months ago and fetches 22-times expected earnings. Bundling it all together, this helps explain why there remains a bid for some near-term protection from index turbulence, and firms such as Wells Fargo are saying the election could be a sell-the-news event regardless of outcome. Plausible, to the degree that a Trump win is seen as “risk on” but somewhat front-run and a Harris victory is perhaps a status quo/gridlock result. What’s priced in? Either way, the market itself continues to be pretty unassailable in its trend and relative unflappability, the majority of stocks gently digesting recent gains last week while the S & P 500 briefly wobbled to touch its September closing level before returning to the vicinity of record highs. No reliable augurs of a coming bear market are in evidence: S & P up 10 of 11 months, making a new high in September, credit spreads resolutely narrow, all point to an upside bias over a span of months, at least. Cyclical leadership, forward earnings forecasts at a record, the Fed in what seems the preferred sort of easing path – unhurried and into a solid economy. .SPX YTD mountain S & P 500, YTD Which leaves the question of just how much upside, if any, a bull should reasonably expect from here. Consensus sentiment is rather overwhelming behind a post-election tension-release rally into year end, but it’s tough to be a strident contrarian in the face of the history that favors such a move. Goldman Sachs got wide attention last week for its new forecast of subpar 3% annual total returns for the S & P 500 over the next decade, which would be worse than 96% of all past ten-year spans. This is where the math takes you from a starting point of 22-times forward earnings and a meager 1.3% initial dividend yield, along with Goldman’s take that the extreme concentration of the index in a handful of world-bestriding growth stocks is a liability given the mean-reverting nature of corporate dominance to wane as capitalism does its thing over time. The firm laid out a range of scenarios with the bull case landing at 7% annual returns, which would be perfectly respectable after 16% yearly haul the past five years. Others on Wall Street went after the Goldman call as misguidedly dour, which is itself possibly an interesting sentiment tell that investors don’t think fat years are followed by lean ones. I tend to think low expectations are a secret weapon for investors who stay involved, perhaps spurring more discipline and higher investment contributions suited for a world in which the market itself is not as generous — while building in the prospect of being pleasantly surprised if things turn out better.
