Economic Update 9-12-2016

• In a light week for economic data, the key release was a disappointing ISM non-manufacturing number, while JOLTs and jobless claims showed continued labor market strength.  A key question focused on by market participants is how these various reports will affect the probability of a Fed interest rate move in a few weeks.

• U.S. equity markets declined, as did most investment-grade bonds, as a result of comments implying a sooner-than-later Fed interest rate move.  Foreign developed markets fell to a lesser degree, while emerging markets bucked the trend with gains.  Commodity markets rose with help from a weaker dollar and higher energy prices.

In a Labor Day-shortened week, equity markets continued their stretch of low volatility until Friday, when stocks fell sharply in response to hawkish comments from key FOMC members and a well-known but controversial bond fund manager, which raised questions about a sooner-than-expected rate hike—contrary to recent market expectations.  The North Koreans also announced another nuclear missile test, which is always a geopolitical wildcard, depending on the number of other newsworthy events in a given week.  From a sector standpoint, U.S. equity returns were led by gains in energy, in keeping with higher oil prices during the week, while all other sectors lost ground—the worst being consumer staples and materials.

Stock and bond have an unpredictable and somewhat schizophrenic relationship with the specter of rising interest rates.  This is easy to forget, but higher rates are technically a positive development, implying that growth is strong enough for an economy to warrant and absorb them (moves also tend to be positive for markets over the intermediate-term); while a lack of rate action is indicative of weak conditions, and, in theory, offers mixed messages for stocks and bonds.  However, when the moment finally arrives, short-term fears of the punchbowl being removed from the party can generate some volatility, as it’s something we haven’t seen in over a decade in any meaningful way.  Unfortunately, the Fed’s over-communication in recent years can mean a hair trigger after any comment from any FOMC member.  Traditionally, no one spent much time worrying about the various Fed governors and their opinions (they were relatively anonymous).  Today, though, many are household names, and their various tendencies (hawkish, dovish, subtle, exaggerative, etc.) are overly-documented, to the point of their discussions being scrutinized through key word search algorithms for changes in tone.

It’s important to note that, whether a rate hike comes in September and/or December, the pace of rate movement upward is likely to be very tempered—based on how things look today.  A significant spike in growth and/or a significant rise in inflationary pressures could cause the Fed to speed up their pace, but current data doesn’t look threatening on that front.

Overseas, the ECB decided against any further easing last week directly, keeping their current stimulus program in place; although, it’s assumed that further easing could happen in the latter part of this year if continued lackluster conditions persist.  This news and weak German and French economic data prompted European stocks to fall off, although not to the same degree as in the U.S., being driven by different dynamics.  By contrast, Japanese stocks were pushed higher by a positive GDP revision upward and other economic data turning out a bit better than expected.

Emerging markets gained on the week, as positive returns in China, other Asian markets and Russia offset weakness in Brazil and Mexico—EM equities have been supported by recent investor flows chasing the strong returns year-to-date.  Oddly, a negative week in Mexico was related to the resignation of certain politicians following a Trump visit, as well as fiscal spending cuts that were likely unrelated to the visit.

U.S. bond prices generally fell on the week with rising rates, mostly at the longer end of the yield curve.  Governments slightly outperformed investment-grade credit, but high yield actually fared better with flat returns and floating rate bank loans gained ground.  There has been higher new supply activity in corporate bond markets—partially a seasonal thing with summer being over and partially a nod to companies wanting to take advantage of low rates before they’re assumed to inch higher.  In foreign bond markets, a weaker dollar turned a negative return for developed market debt into a positive one, with strong gains in Japan offsetting losses in the U.K.  Emerging market bonds fared positively overall.

Real estate lost several percent on the week, a bit worse than broader equities, which was no doubt related to the ‘fears’ of an interest rate increase.  Such an event is a common risk for REIT returns over short-term periods, as we’ve discussed in the past, although the longer-term implications of which (e.g. economic growth, tenant demand) have generally been good for the asset class.  Within the U.S. group, cyclically-sensitive lodging/resorts suffered the worst, while other core sectors industrial, residential, etc. fared better.  Foreign REITs outperformed, with help from a weaker dollar, but the bulk of positive returns were due to Japan.

Commodities experienced a positive week, led by the energy sector, although agriculture and precious metals also proved their diversification benefit with positive results.  West Texas crude rose to just under $46/barrel due an unexpected drawdown in U.S. inventories and continued talk of Russian/Saudi cooperation to ‘rebalance’ (decrease) production.  All of these producers want higher prices, but not so high as to shoot themselves in the foot.  Following the early 2016 tumble in oil prices, early April through now has proven far less exciting for the energy segment, with price movements limited to a fairly precise round-number trading range of $40-50/barrel.  However, the week-to-week results can look far more exciting as a $4-5 rise or fall in pricing at those levels represents a 10% gain/loss in either direction.  Predictions continue to be mixed from firm-to-firm, but on consensus seem to be in the $50-60 range over the next few years, which implies supply reductions from current levels and/or some improved demand from emerging markets.  Targets in the near-term tend to reflect current pricing sentiment, so are naturally subject to ongoing change.  Oddly enough, and a reminder that charts can tell any story you want them to when you change the dates, both spot crude oil and unleaded gasoline are nearly unchanged on a year-over-year basis despite the drama in between.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                                               

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.