These questions are key to the future direction of stock prices.Apr 2018
How will the equity markets react as central banks around the world withdraw monetary stimulus and what about the longer-term impact of fiscal stimulus? These questions are key to the future direction of stock prices. In terms of fiscal stimulus, the Trump tax cuts have already provided a significant boost to stock prices as investors discounted higher earnings driven in part by a lower corporate tax rate. While certainly a positive, the ultimate benefit to stocks depends on how corporations utilize the tax savings and repatriation of overseas profits. Throughout the current cycle, many public companies have taken advantage of generationally low interest rates by borrowing and using the proceeds to repurchase their shares while raising dividends. These actions have been a persistent tailwind for stock prices over the past few years, but over the long term the relationship is more complex. Higher stock prices are ultimately a function of higher earnings and the valuation of those future earnings – often times both. With equity valuations already at the high end of the historical range and unlikely to expand further, corporate earnings will need to continue rising in order for stock prices to move materially higher. This goes back to the long-term impact of tax cuts – and whether savings will be re-invested or simply returned to shareholders in the form of more buybacks and dividends. What we have yet to see is a meaningful pickup in new orders of capital goods or inventory stocking that would signal companies are “ramping up” in anticipation of growth in aggregate demand or because they see attractive investment opportunities in their businesses. These activities are what drive long-term earnings growth and help sustain higher stock prices.
The near-term impact of monetary policy on stock prices, on the other hand, is more difficult to predict. We will be paying attention to not only what central banks do, but what they say. We expect what they will do is gradually raise interest rates while shrinking their balance sheets, which will lead to tighter borrowing conditions. What they say in their statements, though, may be just as important as it provides nuance and guidance regarding future policy. In both the U.S. and the Eurozone, what they are saying is that they will implement changes in policy based on how the economy reacts but also on how equity markets react. Simply put, we believe policy makers prefer to avoid doing anything that might cause a sudden sharp correction in stock prices.
Of course, it is not just central bankers who can cause sudden changes in equity prices. As we noted above, stock price volatility increased sharply during the first quarter as investors reacted to higher than expected wage growth as well as other factors. The rise in price volatility is notable as it follows an extended period of unusually low volatility. Even the January “correction” simply unwound the 10% gain leaving investors right where they started the year, but it made for a bumpier ride. Since the beginning of the current bull market nine years ago, stocks have tended to march steadily higher, past several threats of a more severe correction. Such stock price behavior is unusual but not surprising given the enormous impact of monetary policy across markets. Looking ahead, we see a return to more normal (higher) price volatility that is characteristic of risk assets like stocks. For investors, this presents both challenges and opportunities. Foremost, it represents a chance to examine and perhaps reassess personal risk tolerance. If larger price swings keep you up at night, it may be appropriate to reduce equity market exposure. Conversely, if you have a long-term time horizon, there is likely to be an opportunity to add to stock positions that have cheapened in price. The most important thing is to assess objectives and goals, particularly in cases where there is a defined need for capital or distributions; we are holding reserves in shortterm bond funds to meet these needs, which avoids the risk of having to sell stocks at an inopportune time to meet liquidity needs.
Looking ahead, we believe U.S. equities can still offer decent returns over a longer-term horizon; however, the ability to earn much higher returns from here is likely limited. By virtue of being earlier in their earnings recovery and at lower valuation multiples (see accompanying chart), ex-U.S. markets such as Europe and Emerging Markets should yield higher returns relative to the U.S. market. We continue to look for opportunities and investment vehicles that will participate in the earnings and valuation recovery outside the U.S.
The current bull market cycle will come to an end at some point, but history has shown that even when corrections occur, staying invested has been key. Over time, both stock prices and dividends tend to increase, offering the greatest potential for capital appreciation relative to other asset classes.