U.S. interest rates remain near historic lows more than six years after the end of the Great Recession. However, the Fed is likely to begin raising short-term interest rates in the not-too-distant future. This will put upward pressure on rates across the board, and bond yields may rise. When yields move higher, bond prices fall. In such an environment, if an investor needs to sell bonds before they mature, there can be a capital loss.
While a disciplined approach to maintaining a proper asset allocation is always critical to long-term success, thoughtful investors will want to pay special attention to bond allocations in their portfolio given the likelihood of interest- rate increases.
The flipside to historic low bond yields is that bond prices are at historic highs. If equity markets were at historically high valuations, it would make sense for an equity investor to rebalance an investment portfolio, taking some profit from high stock prices and moving into less richly valued asset classes. And if a stock sell-off was expected in the near future, an investor might reduce equity exposure to the lowest tolerable level in anticipation of that development. The same should hold for bond investors. With yields so low (and prices high) and expectations of pending Fed rate increases, bringing bond allocations down to the low end of target allocation ranges may provide some benefit.
Since crude oil prices collapsed in June 2014, the number of operating U.S. oil rigs has fallen 64 percent, to 572 rigs from 1,609. Despite this, U.S. output kept growing until June 2015, peaking at 9.7 million barrels a day. Production has slipped since then, though it remains at a historically high level of just over 9 million barrels a day. Meanwhile, crude inventories keep rising, hitting a record 1.28 billion barrels, excluding the Strategic Petroleum Reserve.
Crude refining continues at a rapid pace, with output of gasoline, kerosene, and distillates all close to records. Inventories of most refined products also are near seasonal highs. These levels of oil production, refining, and crude and gas inventories are all reflected in pump prices.
The U.S. average retail selling price of gasoline has fallen to $2.32 a gallon, a level last seen briefly in late 2014, and before that during the last recession and earlier, in 2005 (Chart 5).
While the actual dollar benefit to most consumers is relatively small, the psychological effect can be significant. The collapse in crude helped boost consumer sentiment in 2014. A rebound in early 2015 contributed to a drop in sentiment as did the sell-off in equity markets. Most recently, pump prices are falling once again and should help boost consumer attitudes toward spending.
U.S. equity markets have rebounded significantly from the roughly 50 percent declines experienced during the Great Recession. By March 2013, the S&P 500 index had risen from its recession low of 676.15 in March 2009 to its pre-recession high of 1565.15. The large-cap benchmark index continued its upward move, hitting an all-time high of 2130.82 on May 21, 2015. This made the S&P 500 one of the strongest performing indexes in developed markets.
During that time, retailers in the S&P 500 significantly outperformed the benchmark index, gaining 463 percent compared with a 215 percent increase for the broader index (Chart 6). Part of the outperformance may be attributed to strong earnings growth. Over the past five and a half years, earnings-per-share for the Retail Select index rose at an annualized rate of 9.1 percent compared with a 7.8 percent rate for the S&P 500.
On a relative basis, earnings gains for retailers have not outpaced those of the broader index by as much as the index of their share prices has outstripped the overall S&P 500, suggesting that valuations for retailers may be getting elevated relative to the broader market.
Price-to-earnings ratios for both support this conclusion. The P/E ratio for the retail index was 28.1 for the second quarter of 2015 compared with 21.7 for the S&P 500. This represents a 30 percent premium for the retail index over the broader index. That 30 percent premium is down from 52 percent at the end of 2013 but still well above the 15-year average of just 2 percent.
The bottom line is that we expect continued stronger earnings gains for retailers relative to the S&P 500. The current high valuations may curb some of the potential price performance that strong holiday sales gains would suggest for the sector.
As we have noted, investors appear to prefer stocks over bonds. This seems to make sense given the potential for interest-rate increases that could result in capital losses for bondholders. We take our analysis of mutual fund and index fund inflows and outflows one step further, looking into the breakdown of the cash moving into domestic and global equity funds.
The net movement of money into equity funds was solidly positive before the Great Recession but began to slow during the first three quarters of 2008. The investment into equity funds dropped in late 2008 and switched to a net outflow until late 2009. It remained mildly positive from late 2009 through late 2011 but turned negative from late 2011 through the end of 2012. Beginning in 2013 equity inflows accelerated sharply, hitting a record high at the end of 2013. Since that record, equity inflows have slowly faded even while remaining solidly positive.
When we break down cash flowing into domestic funds versus global funds, a more nuanced story emerges. Cash going into both domestic and global funds accelerated sharply in the second half of 2003, but domestic flows quickly reversed course and drifted down until the recession began in December 2007. New investment in global equity funds continued to rise during that period but turned sharply lower and eventually negative during the recession. Since global flows returned to positive territory in late 2009, after the recession’s end, they have strongly outpaced domestic equity inflows (Chart 7).
Two key themes may be driving this. First, U.S. equities and the U.S. economy have performed better than most global equity markets and developed economies. As a result, strategic (passive) investors’ allocations may be overweighted with domestic equities and may need to be rebalanced. Second, global markets that have trailed the performance of U.S. equites may now be seen as cheap, so tactical (active) investors may see enhanced value in global markets. Both patterns may continue until allocations and valuations move closer to desired targets.