Current economic events
Markets appear to be focused on politics while economic data remains solid. Growth in China continues to improve due to upward trending inflation data, and U.S. growth remains on a positive track based on strong job openings, low jobless claims and high consumer confidence. With the Senate tax proposal at odds with the House tax bill, markets have softened because of concerns that stimulus could be delayed. The path to a tax bill is likely to be volatile while politicians, markets and lobbyists negotiate toward a final bill. With the December Federal Open Market Committee (FOMC) meeting on the horizon, inflation data (that’s due to be released this week) and November payroll data are both important data points ahead of the likely rate increase.
Outside the United States, data among the major economies remains modestly positive, including rising inflation pressure in China. Political turmoil remains a risk, especially in the Middle East as Saudi Crown Prince Mohammed bin Salman attempts to consolidate power. Global economic growth would be at risk if there is an outbreak of Middle East conflict, which could lead to a spike in oil prices. In our view, this remains a modest risk and, for now, economic trends continue to point to improving global growth.
While the popular broad-based U.S. indices are near all-time highs amid elevated valuations, the fundamental backdrop remains mostly favorable for U.S. equities. Increasing earnings, restrained inflation and low interest rates provide valuation support and the basis for stocks to trend still higher.
The third quarter earnings season is coming to an end, with roughly 90 percent of S&P 500 companies having reported quarterly results. On balance, companies are reporting broad-based global economic expansion, with recent hurricane activity having significant localized impact, but overall limited effect on the U.S. economy.
- In aggregate, sales are being reported in line with expectations while earnings are exceeding estimates. According to Bloomberg, third quarter year-over-year sales and earnings are increasing roughly 5.5 percent and 7 percent, respectively.
- Consensus expectations are for earnings to increase approximately 10 percent year over year for both 2017 and 2018, with upside in 2018 potentially bolstered by fiscal stimulus.
Risks to equity market progress include:
- Uncertainty surrounding the timing and magnitude of tax reform. This has the potential to weigh on sentiment. Upside to 2018 earnings is, in part, contingent on fiscal stimulus. Currently, tax reform remains a work in progress. At a minimum, a quick and easy path toward tax reform seems unlikely.
- A flattening yield curve. Historically, an inverse yield curve has been an indicator of a looming recession, preceding six of the past seven recessions. While the yield curve remains upward-sloping, a Federal Reserve (Fed) rate hike in December and two to three hikes in 2018 increases risks that the yield curve becomes inverted during the latter half of 2018, which is a potential future headwind for equities.
With third quarter earnings season coming to an end, and looking ahead to next week and Thanksgiving, we expect investor focus to shift toward the holiday sales season. Increasing earnings, constrained inflation and low interest rates provide the basis for stocks to still trend higher. Higher stock prices, firming wages and stable housing are among items boosting sentiment while presenting a constructive backdrop for a favorable holiday selling season.
Fixed income markets
Bond yields finished last week higher while credit spreads widened modestly. Any potential delay in implementation of tax cuts could drive ongoing market volatility. However, our overall view on Treasury debt is little changed in that bond yields will be gradually pushed higher and prices lower by a healthy global economy, rising inflation and a gradual reduction in central bank accommodation. We prefer credit risk over duration at current levels, favoring higher-quality credit, such as investment grade corporate bonds over riskier high yield and emerging market debt.
As tax bill negotiations currently stand, tax-exempt municipal bonds could experience supply constraints as the proposal may eliminate the tax deductibility of certain issuance types. A material reduction in supply would act as a tailwind for municipal bonds. The impact on corporate debt is likely mixed, depending heavily on details not yet finalized. In the near term, issuance is expected to ramp up in anticipation of a possible interest deductibility change. At present, it would be premature to make large reallocations based solely on tax policy, due to the fluid nature of negotiations and uncertainty around passage.
Weakness in the high yield bond space in recent sessions was driven primarily by the communications and healthcare sectors, which comprise a material weight within indices. While popular exchange-traded funds (ETFs) experienced material outflows and moderate price declines, moves by the high yield index and many active mutual funds tracking the space were less pronounced, with prices trading at levels seen as recently as August and September, in some cases. We continue to have a strong preference for active managers in the high yield bond space and believe that a constructive economic backdrop is supportive of prices, despite relatively high valuations.
Emerging market debt spreads widened a bit as a crackdown on political opponents in Saudi Arabia and the resignation of the prime minister in Lebanon have led to growing political uncertainty in the region. Our long-term view of emerging markets is unchanged, believing it is prudent to remain invested through such periods, despite modest short-term volatility. Diversification is proving a meaningful benefit as broad emerging market indices have been minimally impacted, to date.
Real estate markets
The National Council of Real Estate Fiduciaries (NCREIF) third quarter real estate trends report reveals a market in a steady equilibrium. Vacancies ticked down, eliminating the increase seen the previous two quarters and have now been in a narrow range for the past two years. Cap rates, which is a measure of income net of expenses relative to prices, continued to gradually descend, dropping just below 5 percent. Net operating income (NOI) moved slightly lower, as well, but was still at a healthy 5.18 percent for the trailing four quarters. Core commercial property should continue to provide decent returns, with the majority coming from income. However, with NOI still positive, the sector can still produce price appreciation. Publicly traded Real Estate Investment Trusts (REITs) outperformed the S&P 500 over the past week by approximately 1.5 percent, but still trail the broader market by 12 percent for the year. The recent decline in interest rates helped the space outperform since investor outflows have slowed.
Saudi Arabia caused a stir in oil markets last week with the arrest of numerous Saudi princes on charges of corruption, sending the price of crude to its highest level in two years. The recent breakout in oil has been met with increasing rig counts in the United States. For now, it appears higher prices will be met with increased U.S. shale production, which should help keep prices in check.
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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.
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Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Exchange-traded funds (ETFs) are baskets of securities that are traded on an exchange like individual stocks at negotiated prices and are not individually redeemable. ETFs are designed to generally track a market index and shares may trade at a premium or a discount to the net asset value of the underlying securities. Mutual fund investing involves risk and principal loss is possible. Investing in certain funds involves special risks, such as those related to investments in small- and mid-capitalization stocks, foreign, debt and high-yield securities and funds that focus their investments in a particular industry. Please refer to the fund prospectus for additional details pertaining to these risks. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.
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