While the deal was an important positive for markets in that it removed a significant systemic risk, the rally in stocks appears excessive.
For the week, the Dow Jones Industrial Average gained 1.1% to close at 15,399, the Nasdaq Composite rose 3.2% to 3,914, and the S&P 500 Index climbed 2.4% to 1,744, a new record high. In fixed income markets, Treasury yields fell (as prices correspondingly rose), with the yield on the 10-year Treasury falling from 2.69% to 2.59%.
Temporary deal solves nothing
The compromise that Washington managed to eke out at the 11th hour had one purpose: to temporarily reopen the government and avoid a technical default on US debt. Nothing else was accomplished.
The market will face the same issues again in early 2014, at which point not much will have changed. By most political metrics, such as voting records, both the House and the Senate are more polarised than they have been in at least a century. Given how far apart the two parties are philosophically, the type of short-term deal that was struck last week may become a template for what to expect over the next year, and potentially for the next three, if the political status quo holds after the 2014 mid-term elections.
Near-death experience likely slows economy
From an economic standpoint, the shutdown and near-death experience on the debt ceiling represent another modest, though not fatal, obstacle for the economy. Fourth-quarter growth will be a bit slower due to the mechanical impact of the US government shutdown.
Probably the bigger hit comes from diminished consumer confidence, which touched a two-year low last week, according to Bloomberg’s proprietary metric.
Part of the drop in confidence – which actually began over the summer – stems from the government shutdown, but another portion can be attributed to some cooling in the housing market. While home prices continue to rise, other housing metrics have deteriorated modestly over the past six months.
Housing starts and permits have slid while inventory levels have risen slightly. Finally, mortgage applications have plunged, mostly due to a significant drop in refinancing activity amid higher interest rates.
Positive for bonds: low for longer from the Fed
While a softer housing market is not great news for the economy, there is a silver lining of sorts from an investment standpoint. Housing is critical to the recovery, and the big danger to housing is that mortgage rates rise too far or too fast. The Fed knows this and will likely err on the side of caution. This means any tapering (i.e. reduction in the Fed’s bond-buying program) is likely to initially focus on Treasuries, while the central bank continues to buy mortgage-backed securities (MBS) in an effort to keep mortgage rates low.
While this may result in a narrowing of mortgage yields versus Treasury yields, MBS will still offer incremental yield and will probably hold up better than the Treasury market. As a result, we are upgrading our view of MBS to overweight from neutral, relative to other fixed income investments.
US stocks fully valued: consider international
We expect that continued Fed accommodation will help support stocks. However, last week’s rally seemed aggressive for a few reasons: all Congress could fashion was a temporary solution, economic growth remains soft, and the Fed will start to taper at some point in the next six months or so.
Despite all of this, valuations have continued to climb. US stocks are now trading at roughly 2.5x book value, a 15% increase from the end of 2012.
In other words, the majority of this year’s gains have come through higher multiples, not a boom in corporate earnings. And while US stocks still look reasonable compared to history, they are looking fully valued relative to an environment of 2% growth. This does not mean the market is due for a correction, but simply that going forward, gains need to be more driven by earnings growth; otherwise, US stocks will start to climb into overvalued territory.
In the meantime, we continue to see good bargains outside the US. Within the US, the energy and technology sectors appear to be more reasonably priced.
