Stocks Grind Higher
Stocks continued to climb higher in the United States last week, despite sporting pricey valuations. The Dow Jones Industrial Average climbed 1% to close the week at 17,810 and the S&P 500 rose 1.17% to 2,063, both setting new records. Meanwhile, the Nasdaq Composite Index was up 0.51% to 4,712. The bond market was little changed, with the yield on the 10-year Treasury essentially flat at 2.31%.
We would identify three trends that are helping to support equities: additional monetary stimulus from foreign central banks, a wave of mergers and low and stable interest rates. However, with rates remaining low and investors continuing their reach for income, defensive, income-oriented stocks may be overvalued.
A Confluence of Factors Providing Support
Equities have now rebounded more than 12% from their October low, in the process pushing valuations to their highest level since 2009. Nevertheless, stocks continue to benefit from several factors, including monetary stimulus, a fresh wave of mergers and acquisitions (M&A) and low and stable U.S. rates.
On the monetary front, the latest shot of adrenaline came from China. On Friday, the People's Bank of China cut interest rates for the first time in two years, igniting a global rally in stocks.
Equities also continue to benefit from a wave of M&A, with deals now totaling over $3 trillion for the year. Last week witnessed mega-mergers in both energy and pharmaceuticals: a $35 billion takeover of Baker Hughes by Halliburton and Actavis acquiring Botox maker Allergan for $66 billion.
The third factor supporting equities: low and stable bond yields. Despite the two best back-to-back quarters of economic growth since 2003, U.S. long-term yields refuse to budge. Declining inflation expectations are part of the reason yields are remaining so low. Five-year inflation expectations –– derived from the Treasury Inflation Protected Securities market –– recently hit 1.49%, the lowest level in four years.
This drop in inflation expectations has not gone unnoticed by the Federal Reserve (Fed). Recently released minutes from the last Fed meeting referenced this trend. For now, the Fed persists in its belief that inflation will "move back to the committee's 2% target over the medium term," a view supported by last week's release of slightly higher-than-expected producer and consumer inflation numbers.
In addition, U.S. bond yields are remaining low because yields in other developed countries are even lower. Europe's recovery remains weak and Japan has just slid into yet another recession. With German and Japanese bond yields well below 1%, a 2.35% yield on a 10-year U.S. Treasury seems attractive in comparison. This entices investors to buy Treasuries, supporting their prices and keeping yields low.