Week of October 8, 2018
Current economic events
Despite a decent amount of important economic data coming out, interest rates were the big driver of financial markets last week. The yield on the 10-year Treasury bond rallied from 3.07 percent to 3.22 percent, pressuring yield proxy assets like real estate investment trusts (REITs) and utilities, and contributing to investor concern about quickly rising discount rates. The rising yields signal investors’ increasing tolerance for higher-risk assets and confidence in future economic growth.
U.S. economic data mostly echoed this sentiment. Most optimistic was the U.S. employment report from the Bureau of Labor Statistics. The unemployment rate broke through an October 2000 low to reach its lowest level since 1969 while nonfarm payrolls growth continued to trend higher on a year-over-year basis. However, wage growth moderated from its best annual pace since 2009, a potential headwind for inflation. Purchasing manager surveys from the Institute of Supply Management (ISM) were mixed, with the manufacturing index falling off highs while the non-manufacturing index jumped to its best levels since 1997. Both are still indicative of robust expansions of business activity throughout the economy. Concerns about a loss of momentum in some data remain, but thus far, the U.S. economy continues to hum.
Internationally, the story continues to be more muddled. Japanese data was mostly worse, putting the brakes on a stock market rally after the Nikkei index reached a 27-year high early in the week. Specific concerns were over real income declines and near-stagnant purchasing manager sentiment in the service sector, though a three-year high in personal consumption expenditure growth is a sign that Japanese consumers may be feeling more confident. Despite a nearly decade-low unemployment rate reading the in eurozone, markets continued to respond negatively to weakening manufacturing PMI and softer producer inflation. Incremental news about Italy’s budget agreement and Brexit have also contributed to the downtrend.
Concerns remain substantial in emerging markets. Chinese PMI from Markit/Caixin indicated no growth in the manufacturing sector for the first time in a year-and-a-half, reflecting increasing economic weakness from the de-risking of the financial sector and U.S. tariffs. Deeply dispirited Brazilians headed to the polls, with Jair Bolsonaro and Fernando Haddad headed to the runoff election in three weeks, neither of whom have records of market-friendly policies and could undo some of the reforms made by the unpopular outgoing president Michel Temer. This comes amid increasingly “stagflationary” conditions in the Brazilian economy as a recovery from the country’s worst recession on record fades. Despite growing on balance, trends continue to point down in many emerging markets.
U.S. equities traded modestly down last week, capped off by a still Goldilocks-like “not too hot, not too cold” jobs report that is showing signs of heating up. On balance, the labor market continues to tighten, putting upward pressure on wages, causing interest rates to climb, which eventually presents a headwind for stocks. Our year-end 2018 price target for the S&P 500 is 3,000 (based on a multiple of 19 on earnings of $160), roughly 4 percent above the October 5 close. Our year-end 2019 price target is 3,325, nearly 11 percent more than our projected year-end 2018 target.
The fundamental backdrop of rising earnings, non-problematic inflation and still relatively low interest rates versus historical levels continues to provide valuation support while serving as a basis for stocks to trend higher, albeit at a more subdued pace. From current levels, upside to equity prices is likely to be bolstered primarily by earnings growth versus multiple expansion. Multiples tend to eventually compress during periods of rising inflation and higher interest rates. The third quarter earnings season unofficially begins on October 12 when several money center banks are slated to release results.
The technical outlook remains generally positive following last week’s price decline. Importantly, pullbacks are within the normal ebb and flow of an upward-trending market. With credit spreads (difference between corporate high yield and 10-year Treasury yields) remaining largely unchanged last week, the recent pullback in equity prices seems to be more of a consolidation than change in trend. The S&P 500 ended last week essentially at the 50-day moving average and still above 100- and 200-day moving averages. A violation of 100- and 200-day moving averages would undoubtedly add to investor angst.
Sentiment is mixed, spurred by rising interest rates and a general heightened degree of investment difficulty. Bonds matter, trade policy remains a work in progress and the midterm elections are less than one month away. As interest rates trend higher, bonds become a more viable alternative to equities and valuation multiples tend to become compressed. The longer-term implications of trade are still to be determined. The question is the extent to which tariff-tensions will impact business confidence, the global supply chain and, eventually, company earnings. In addition, surprise election outcomes can be disruptive. In the interim, earnings are a key near-term driver of equity prices following third quarter releases. Of looming concern is what happens to sentiment and equity prices when investor focus shifts to 2019 and a slower rate of earnings growth.
Fixed income markets
U.S. Treasury bond yields surged higher last week due to strong economic data and comments from Federal Reserve (Fed) Chairman Jerome Powell. The 10-year Treasury yield rose above 3.2 percent and the two-year yield approached 2.9 percent. Growth prospects improved, with the ISM non-manufacturing Index rising to a new peak in the third quarter. Powell stated, “Very accommodative policy is no longer appropriate in the current environment … we may go past neutral [the level at which interest rates neither stimulate nor restrict economic growth], but we’re a long way from neutral at this point.” These comments prompted investors to increase the odds of additional Fed rate hikes, in turn pushing bond yields higher. We believe yields will continue to rise due to strong domestic economic fundamentals, declining central bank purchases and robust Treasury issuance. The market continues to underappreciate the likely pace of rate increases from the Fed despite the recent move. We continue to recommend shortening portfolio maturities due to our expectation for rising yields, combined with limited incremental yield available by extending maturities.
Fed rate hikes should continue pushing short-term bond yields higher. The Fed still expects to increase rates one more time in 2018 and three more times in 2019. Powell’s comments last week pushed market expectations higher. The futures market probability for a December hike increased last week from 76 percent to 86 percent. Expectations for the number of hikes through December 2019 increased from approximately two-and-a-half to three. This week, September Consumer Price Index and wage data will provide further insight into inflation expectations and monetary policy projections. We anticipate further upward pressure on bond yields if growth and inflation data remain at or near projected levels.
We maintain a balanced view of investment-grade corporate debt relative to Treasuries for now. Corporate debt valuations have remained elevated despite the rapid rise in Treasury yields. There will likely come a point at which rising funding costs will dampen economic activity and corporate credit fundamentals. However, domestic economic fundamentals remain strong for the time being, corporate defaults remain low and issuance has been light. Credit fundamental trends have been mixed, with rising leverage being counterbalanced by improving debt coverage and return on capital ratios.
Real estate markets
Publicly traded REITs fell 2.8 percent last week, underperforming the broader market by 1.8 percent. For the year, REITs trail the broader market by 10.5 percent. With the 10-year U.S. Treasury yielding more than 3.2 percent, it is not surprising that REITs are under pressure. Investor motivation to hold risky assets declines as the payment to hold riskless asset increases. As such, we believe the real estate market could decline further if 10-year rates rise above 3.5 percent.
Oil was strong last week, with West Texas Intermediate (WTI) crude rising 1.5 percent. Brent crude hit another cycle high and the Brent/WTI spread remained wide. The market will continue to worry about Iran sanctions and potential supply disruption, which may keep prices strong. However, the oil market could be set up for a significant “buy the rumor, sell the news” moment once Iranian sanctions are finally implemented in November.
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