Markets stretch for return as the cycle matures and the Fed enters an uncertain new era.

When my colleague Erik Knutzen wrote last week about the “scarily good” macroeconomic and earnings data that emerged around Halloween, he certainly caught the feeling of the moment. The S&P 500 Index spent the week flirting with its record-high level. The CBOE VIX Index dipped back below 10.

I share Erik’s view on economic and earnings data, and the potential for increased inflation next year that they underpin. In that scenario, risky assets may well enjoy continued support. But, just as Erik would be the first person to warn about market complacency in response to strong fundamental data, I would observe that, when sentiment is as bullish as it is today and valuations in some parts of the market are so stretched, long-term equity investors need to think about what lies 18, 24 or 36 months down the road rather than six or nine months.

Over that longer time horizon, the probability of markets seeing a dose of downside volatility is quite high. When that happens, we will have someone chairing the Federal Reserve whose views about what to do when risk appetite evaporates are currently unknown, or at least untested. The stakes are high for investors thinking about adding risk to their portfolios over the coming year.

Narrow Leadership in Equities, Loose Standards in Credit

Erik’s post did actually draw attention to one of the more worrying signs of bullish sentiment in equities: the market leadership of the “FANG” stocks. Larger companies, higher-quality companies and growth stocks have outperformed to an extraordinary degree this year. The Nasdaq Index is up more than 25% year-to-date while the Russell 2000 Value Index is barely in the black.

Historically, that narrowness of sentiment has not been a good sign for equity markets. It indicates that investors are chasing winners rather than being comfortable investing for more broad-based growth—a phenomenon typical of late-cycle behavior. Some catch-up from smaller companies and cyclicals would be reassuring, and we were encouraged to see some evidence of that in September—but it may already have fizzled out, with U.S. small-cap indices retracing to six-week lows last week.

In fixed income, we see very tight credit spreads and covenants that are weakening or disappearing altogether as investors chase yield and ignore certain risks. In response to this, my colleagues in high yield have positioned portfolios more defensively. In Treasury markets, yield curves have been flattening aggressively—a sign, in the past, of more challenging times to come.

It is true that we now have tax reform bills from both the House of Representatives and the Senate, raising the possibility of pro-growth legislation being achieved this year as long as these competing versions can be reconciled. Tax reform is likely to benefit smaller companies, which have higher effective tax rates. It may even extend this economic expansion. But it is still undeniably late in the cycle.

A New Era for the Fed Just as the Cycle Turns

The new chair of the Fed, Jerome Powell, may preside over a much tougher four-year term than his predecessor. Powell’s lack of clearly articulated economic views makes it very difficult to judge how he will respond to the inevitable economic downturn.

Fed watchers point to his good use of well-trained support staff at the Fed over the past five years. They expect him to deepen the consensus-led decision-making advanced by Janet Yellen. But consensus may be difficult to achieve without clear authority or experience serving as chair, especially during a period when senior Fed personnel are rotating. The announcement of Bill Dudley’s retirement from the New York Fed puts an end to the powerful Yellen-Fischer-Dudley triumvirate that has been so influential in recent years, pitching us into what feels like a new era for the central bank just as the economic waters get rougher as we move into the late stage of the current cycle.

With these risks on the horizon, investors face a choice as to how to use the current bullish sentiment in markets. Do they ride the likely momentum over the coming months? Or do they use this rally to gradually reduce risk?

In Case You Missed It

  • Eurozone Producer Price Index:  +0.6% in September month-over-month and +2.9% year-over-year
  • Eurozone Retail Sales:  +0.7% in September
  • U.S. Consumer Credit:  +5.5% annualized rate
  • U.S. JOLTS Job Openings:  +0.05% to 6,093K openings in September

What to Watch For

  • Wednesday, 11/15:
    • U.S. Retail Sales
    • U.S. Consumer Price Index
  • Thursday, 11/16:
    • NAHB Housing Market Index
    • Eurozone Consumer Price Index
  • Friday, 11/17:
    • U.S. Housing Starts & Building Permits

– Andrew White, Investment Strategy Group

Statistics on the Current State of the Market – as of November 10, 2017

Market Index WTD MTD YTD
S&P 500 Index -0.1% 0.4% 17.3%
Russell 1000 Index -0.2% 0.3% 17.1%
Russell 1000 Growth Index 0.1% 0.7% 26.2%
Russell 1000 Value Index -0.4% -0.1% 8.6%
Russell 2000 Index -1.3% -1.8% 9.9%
MSCI World Index -0.2% 0.2% 19.0%
MSCI EAFE Index -0.4% -0.1% 22.2%
MSCI Emerging Markets Index 0.2% 0.9% 33.8%
STOXX Europe 600 -1.4% -1.5% 21.9%
FTSE 100 Index -1.6% -0.7% 7.8%
TOPIX 0.4% 2.0% 20.9%
CSI 300 Index 3.0% 2.6% 26.7%
Fixed Income & Currency      
Citigroup 2-Year Treasury Index 0.0% -0.1% 0.4%
Citigroup 10-Year Treasury Index -0.5% -0.3% 1.9%
Bloomberg Barclays Municipal Bond Index 0.2% 0.4% 5.3%
Bloomberg Barclays US Aggregate Bond Index -0.4% -0.2% 3.0%
Bloomberg Barclays Global Aggregate Index 0.1% 0.0% 5.8%
S&P/LSTA U.S. Leveraged Loan 100 Index -0.2% -0.2% 2.7%
BofA Merrill Lynch U.S. High Yield Index -0.8% -0.8% 6.6%
BofA Merrill Lynch Global High Yield Index -0.6% -0.7% 8.9%
JP Morgan EMBI Global Diversified Index -0.8% -1.0% 8.3%
JP Morgan GBI-EM Global Diversified Index 0.5% -0.1% 10.9%
U.S. Dollar per British Pounds 1.2% -0.4% 7.0%
U.S. Dollar per Euro 0.4% 0.1% 10.6%
U.S. Dollar per Japanese Yen 0.9% 0.3% 3.0%
Real & Alternative Assets      
Alerian MLP Index 0.2% 0.4% -9.1%
FTSE EPRA/NAREIT North America Index 2.4% 3.3% 4.8%
FTSE EPRA/NAREIT Global Index 1.5% 2.2% 12.8%
Bloomberg Commodity Index 0.5% 1.3% 0.5%
Gold (NYM $/ozt) Continuous Future 0.4% 0.3% 10.6%
Crude Oil (NYM $/bbl) Continuous Future 2.0% 4.3% 5.6%

Source: FactSet, Neuberger Berman.