Economic Update 10-08-2018

• Economic data for the week was highlighted by a weather-suppressed but otherwise decent employment report, strong results from other labor metrics such as private employment and claims, and mixed manufacturing results.
• Equity markets in both the U.S. and overseas experienced a negative week as interest rates ticked sharply higher.  As expected, fixed income was similarly affected across the board.  Commodities, however, ticked higher due to stronger agricultural and energy prices.

U.S. stocks lost ground for the week on net, with large caps holding up better than small by a significant margin.  Agreement on a draft North American trade treaty replacement for NAFTA, known as USMCA, buoyed stocks early in the week but this positivity was later hampered after comments from the Fed surrounding the strength of the economy pushed interest rates higher—punishing fixed income and equities.  From a sector standpoint, energy and utilities both gained nearly +2%—the latter being a bit of surprise due to interest rates rising, despite a preference for defensive stocks—followed by financials, which benefitted from the higher rates.  On the other hand, consumer cyclicals and technology each fell sharply.  In the case of consumer cyclicals, sentiment toward Amazon—itself a quarter of that sector following the recent reshuffling—due to the decision to raise employee wages to $15/hour and rumors of substantial Chinese hacking activities.

Earnings will be coming in over the next few weeks for Q3, with expectations remaining high on a year-over-year basis—falling in the range of +19% year-over-year growth, per FactSet.  This is actually a few percent lower than was initially forecast a few months ago, and below the +25% growth levels from Q1 and Q2 of this year.  A portion of this decline is due to a higher starting point, but also from negative company guidance.  Revenue growth is expected to come in at a rate of +7%, while the forward P/E for the S&P stands at 16.7—a bit above its long-term average, but not as extreme as some may have expected.

Foreign stocks also lost ground during the week due to bond yields in the U.S. and elsewhere rising, as well as continued contention in Europe over Italy’s government budget deficit.  Japanese stocks also fell as the IMF expressed concern over pressures in achieving ample enough economic growth.  The preliminary budget deficit in Italy of -2.4% (which has now supposedly improved to -2.1% for 2020) caused turmoil in European stock and bond markets the week prior, with negative sentiment continuing.  This is most directly due to possible bond downgrades that could occur for Italy due to higher debt levels than are believed to be sustainable, as well as fundamentally due to the Eurozone limitation on deficits larger than -3% and, more importantly in this case, debt of more than 60% of GDP—per the original Maastricht Treaty of 1992.  The current budget could lead Italy down a difficult trajectory of debt far beyond this level, which pits populist politics into a more difficult position, of either scaling back to appease broader EU leadership, or stoke the flames of anti-EU rhetoric, which again brings up the possibility of Italy rejecting euro membership (although this is still considered to be a less likely scenario at this point).  An Italian departure could certainly prove to traumatic to European and global markets, but could well be more disastrous to Italy itself, likely resulting in a sharply negative currency adjustment, downgrade in credit rating and sharply higher interest rates.

Emerging market equities fared the worst, with strength in Brazil as the election season winds down and the right-wing populist reform candidate showing strength, but India substantially weaker due to rising oil prices (being an oil importer) as well as perceived trouble with several non-bank financial firms—where a key firm defaulted and required government intervention.  Turkey again struggled, as inflation accelerated to a 25% pace, which, on top of an already-weak currency, may require additional interest rate increases to help stabilize fundamentals.  This could be thought of as a Paul Volcker-like response to inflation in the early 1980s in the U.S., albeit without the luxury of a global safe haven currency and consistently supportive political establishment.

Bonds were the big news item of the week, with 10-year treasury yield reaching its highest level in seven years at just under 3.25%.  Key catalysts for the jump included Fed Chairman Powell’s comments concerning strength in underlying economic conditions (described as ‘remarkably positive’, with the current expansion continuing for ‘quite some time, effectively indefinitely’), continued strength in labor market and manufacturing metrics, as well as perhaps technical bond market factors, including sales from momentum traders as yields increased.  As of late, even the more ‘dovish’ members of the FOMC, who had been advocating a slower path of rate increases, have been jumping on board for the current path of additional hikes over the next year, where further hikes are now seen as a higher probability.  Notably, comments from Powell and others on the committee about a possible willingness to let fed funds rates drift up ‘beyond neutral’ has added uncertainty to the recent economist focus on the neutral rate alone (called r-star) being the end point for this stage of monetary policy.

Due the higher rates, U.S. bonds experienced their worst week in some time, with treasuries and both high yield and investment-grade corporates losing nearly a percent.  Floating rate bank loans were the only fixed income sector to gain a small amount of ground during the week.  A stronger dollar and higher rates both punished foreign debt by over a percent in both developed and emerging markets, in USD and local currencies.

Real estate fell by several percent on the week, in both the U.S. and abroad, in keeping with a typical response to higher interest rates.  Residential/apartment REITs fared slightly better, while lodging/resorts fared worst for the week.

Commodities gained ground during the week, with all segments higher, led by agriculture and energy (mostly in the natural gas segment).  Crude oil gained during the week before falling back to end at just over $74/barrel, a net increase of +1.5%.  Oil pricing continues to be driven in large part by concern over the anticipated supply reduction from Iran as additional sanctions are imposed next month.

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.