Daily Traders Edge

Nation’s strong economy could supercharge stock returns, but watch out on bonds

August 09
10:01 2018

The U.S. economy just got its best report card in nearly four years. If growth truly is ratcheting upward on a sustained basis, as the White House suggests, then that could alter the outlook for stocks, bonds, housing and other investments.

The higher-growth scenario becomes more likely after a second-quarter rise in U.S. gross domestic product to 4.1 percent, the best showing since the third quarter of 2014. Some economists were quick to dampen the enthusiasm – pointing out, for example, that exports for products like soybeans jumped before tariffs took effect.

But others think a more permanent higher-growth outlook is in the cards, including Treasury Secretary Steven Mnuchin, who cited the potential for four or five years of growth in the range of 3 percent-plus, fueled by last year’s income-tax cuts. An economic second wind, if it materializes, would come amid what is already one of the longest expansions ever.

Here’s how that might play out for key investment categories:

Tailwind for stocks

A shift to higher economic growth should be good for stocks, driving up corporate profits and allowing companies to strengthen their balance sheets further while delivering more money to investors as dividends and boosting merger activity. Volatility could intensify, and bonds could become more competitive with stocks if yields rose. But overall, it’s hard to envision the stock market crashing if economic growth picks up.

Stock prices have surged during the current expansion, but valuations don’t appear all that lofty. Average price-earnings ratios based on expected forward earnings for the next 12 months, for stocks in the Standard & Poor’s 500, stand around 16. That matches the average of the past 25 years, according to JPMorgan Asset Management.

Some investors are concerned that corporate profits are nearing a peak for the current cycle. But if economic growth picks up, profit momentum likely would continue.

The longest bull market of roughly the past century was 113 months, spanning from October 1990 to March 2000. Stocks have advanced for 112 months in the current cycle (through July), but the gains haven’t been as large, suggesting there’s still room to run.

Higher CD yields

Reflecting the often-sluggish pace of the current expansion, interest rates and inflation have remained subdued. Both have picked up a bit, but nothing like normally would be the case after nine years of economic growth.

The average one-year certificate of deposit has risen to 0.7 percent from around 0.43 percent at the start of the year, while-money market deposit accounts have inched up to 0.2 percent from 0.14 percent, said Greg McBride, chief financial analyst at Bankrate.com.

Economic growth at a higher, sustained pace likely would lead to rising yields for ultrasafe instruments, but inflation also could accelerate. “If inflation rises right alongside interest rates, it becomes a hollow victory for savers as they don’t gain any real ground in terms of buying power,” said McBride.

The rate scenario of the past decade has been dismal for savers. Someone who kept $100,000 in a six-month CD last year would have earned only about $400 in interest, down from roughly $5,200 in 2006, according to JPMorgan.

Bond risks more pronounced

Interest rates haven’t risen by much during the economic expansion, but they have increased enough so far this year to trigger modest losses for bonds and bond mutual funds (rates move inversely to bond prices). Bonds rarely lose as much ground as stocks during downdrafts, but negative total returns do occur every five years or so.

To minimize the damage, cautious investors should stick with bonds or bond mutual funds with shorter maturities of maybe five years or less. If interest rates keep pushing higher, these investments wouldn’t get hurt as much as bonds with longer maturities.

Continue Reading at USA Today

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