Corporate profits have been rising on the back of a growing economy and investors have been adding more to their U.S. equity positions. However, the influx of investments has now put the domestic markets at higher than average valuations. High valuations do not necessarily mean that people should not be invested in the market, but normally high valuations are a pretty good indicator of lower returns for the future. In addition, we have gone a long time without a significant economic downturn. About this far into the economic and investment cycle (approximately 8 years) there are usually signs that show some type of economic deterioration. However, we just received some economic news that tells us that this doesn’t appear likely, at least for a while.
A report from the Institute for Supply Management (ISM) reported that manufacturing activity exceeded expectations. A reading of over 60 (anything above 50 is expansionary) for the month of September was the best in thirteen years. The reason this appears to be is that our economy is benefiting from a resurgence in our industrial cycle. In 2014/16 a collapse in commodity prices appear to have effectively reset the clock on the industrial sector's cycle which has been borne out by the surge in the ISM data since the start of last year. While we shouldn’t only be looking at one economic indicator it is an important one. It is also important to note that looking beyond one month is important as well, but the 12- month moving average at 56.2 is now at its highest level since September 2011.
Another very important detail in the report to keep track of though, is the breakout of the Prices Paid survey to 71.5, the highest since May 2011, with the 12- month moving average at 63.5, the highest since December 2011. This suggests that reflationary forces continue to build in the industrial sector. The Fed tends to focus on the CPI (Consumer Price Index) and PCE (Personal Consumption Index) numbers as they are more geared to the experience of prices for the consumer. It makes sense that the monitoring of the inflation for the consumer is the most important. As a group the consumers consist of about 70% of our economy, however it is very difficult to imagine inflation not increasing for the consumer while the prices for manufacturers go up. Eventually the prices that are rising for the sellers of their goods will translate into higher prices for those who buy them.
Given the recent strong indicators that our economy is growing indicates it can be advisable to maintain an allocation in U.S. equities. (It is advised that you speak with your investment advisor as the ability to take risk is specific to your personal situation) A growing economy gives ballast to corporate profits which help support the valuations that we are currently paying for stocks in the U.S. equity market. Having stated this, we also need to be mindful that as inflation increases so will interest rates. We have experienced very low interest rates for quite a while and we may have developed some complacency around this. We need to remember that the U.S. and other developed countries’ economies have experienced extremely supportive monetary policies (Quantitative Easing) and one of those Countries’ (U.S.) is in the process of reversing this. As interest rates and inflation rise, the prices of things go up and the consumer is less likely to keep buying unless they feel confident about their job and that their pay will more than keep up with these rising prices.
In summary, a significant exposure to U.S. equities still seem to be a good decision for many investors at this time. However, it would also be wise to look for opportunities to diversify into areas of the world that will be less affected by a reversal of the Quantitative Easing. (please look out for the article “Who benefits from the reversal of Quantitative Easing?”)