High profit margins and low Treasury yields continue to support lofty equity valuations. The S&P 500’s 1.9% annual dividend yield is very attractive compared to the 2.16% 10 Year Treasury Yield when taking taxes into account. This has helped propel the S&P 500 to a stellar 8.7% return over the first half of the year.
Optimism around equity growth remains high as evidenced by stocks as a percentage of household assets being near all-time highs. There is some pause for concern however as we enter the slower summer months of July and August. Among these are signs of slowing growth, narrow breadth and a flattening of the yield curve.
The short-term Treasury yield is set by the FOMC. It reflects their view on inflation and whether they need to loosen or tighten monetary. In an effort to normalize policy ahead of unwinding its massive 4.5 trillion of debt, the FOMC recently raised rates for the third time in six months this June. This brought the short-term rate to 1.0-1.25%. They also maintained their outlook for one more rate increase in 2017.
While the short-term rate is set by the FOMC, the long-term yield is set by inflation expectations of investors. The current 10 Treasury rate fell below 2.20% at a time when the FOMC is raising rates.
This is concerning because a flattening yield curve means that investors expect a lower rate of inflation going forward (long term yield) than the FOMC. If the yield continues to flatten and eventually inverts (short-term rates higher than long- term rates) it would cost more to borrow for the short term than the long term. This occurred most recently in 2000 and 2006 and has always led to a recession when it has occurred. While we have a way to go, be sure to keep an eye out on these key rates.