August economic data broadly missed market expectations, as the Citi U.S. Eco Surprise Index, a gauge of whether or not key economic data releases beat or missed market expectations, fell from 16.30 at the end of July to 13.50 at the end of August.
What’s more, the index reached a 52-week high on July 26th , with a reading of 43.10, the highest reading since December 2014, highlighting recent weakness. The second look at Q2 GDP was revised down slightly to +1.1% Q/Q, from +1.2% Q/Q prior, even as personal consumption, which represents nearly 70% of the U.S. economy, rose at a +4.4% annual rate, from +4.2% prior, and ahead of expectations for an unchanged reading.
Non-farm payrolls rose +255,000 in July, ahead of market expectations for a +180,000 gain. Net revisions from the prior two months totaled +18,000, adding to an overall strong employment report. The headline Unemployment Rate was unchanged at 4.9%, while the Underemployment Rate rose slightly to 9.7%, from 9.6% prior. The Labor Force Participation Rate ticked up slightly to 62.8%, from 62.7% prior.
Perhaps most importantly, average hourly earnings rose +0.3% M/M, ahead of market expectations for a +0.2% M/M gain. On an annual basis, wages rose +2.6% Y/Y in July, continuing an upward sloping trend of rising wages and a strengthening employment picture. Headline inflation, as measured by the Consumer Price Index (CPI) was unchanged in July, while CPI ex- Food and Energy rose +0.1% M/M, slightly less than the +0.2% M/M expectation.
On a year over year basis, headline CPI rose +0.8% in July, shy of expectations for a +0.9% Y/Y gain. Stripping out food and energy, core CPI rose +2.2% Y/Y in July, short of estimates for a +2.3% Y/Y gain. While CPI continues to remain healthy, the Fed’s preferred inflation metric, the core Personal Consumption Expenditure (PCE) Index rose +1.8% Q/Q, ahead of the prior reading of +1.7% and an unchanged expectation.
From a housing standpoint, home prices leveled off slightly, with the S&P CoreLogic CS Index rising +5.1% Y/Y in June, in line with expectations. Housing starts rose +2.1% M/M to an annualized 1.21 million rate in July, ahead of expectations for a decline to 1.18 million, while building permits fell -0.1% M/M to a 1.15 million annualized rate, missing expectations for a +0.6% M/M gain to 1.16 million.
Additionally, New Home Sales rose +12.4% M/M in July to a 654,000 annualized rate, beating market expectations for a -2.0% M/M decline to 580,000, while Existing Home Sales fell -3.2% M/M to 5.39 million units, shy of expectations for a -1.1% M/M decline to 5.51 million units. Lastly, the National Association of Home Builders (NAHB) housing price index rose from 59 in July to 60 in August, continuing to show positive momentum in the housing market.
Domestic Equity
U.S. equities finished out the month of August in positive territory, continuing an upward trend post “Brexit.” Small-caps led the market higher, rising +1.36%, while mid- and large-caps followed suit, rising +0.50% and +0.14%, respectively. Small-caps have emerged as market leaders over the past few months, and are outperforming their mid- and large-cap peers on a year to date basis, up +13.14%. The rally in small-caps has been mirrored by mid-caps as well, which are up +13.12% on the year, albeit stealthily.
Large-caps, as measured by the S&P 500 have lagged their smaller cap brethren, gaining “only” +7.82% on the year. Not bad for a year in which oil fell below $30/bbl in February, and large-cap equities were once down nearly double digits. Within the large-cap space, much dispersion has occurred at the style and sector levels. From a style perspective, Growth stocks as measured by the S&P 500/Citi Growth Index, lagged Value stocks, as measured by the S&P 500/Citi Value Index, by 78bps on the month.
On the year, the delta between Growth and Value stands at +381bps in favor of Value stocks thanks to the rise in Energy stocks (+15.17% on the year), which are a large component of the Value stock index. At the sector level, a rotation out of defensive sectors such as Telecoms (-5.67%), Utilities (-5.62%), and Healthcare (-3.32%) stocks, and into more cyclical sectors such as Financials (+3.83%), Technology (+2.12%), and Industrials (+0.83%) clearly took place in August, and may continue as the Fed gears up for a potential interest rate hike in September or December.
Logically, as interest rates get set to rise, the relative attractiveness of defensive sectors, which have run up in price so far this year and look relatively expensive, should wane. Telecoms and Utilities remain the two top performing sectors on a year to date basis, having gained +18.96% and +15.67%, respectively.
Should interest rates rise, these sectors could be at risk, while year to date laggards such as Financials, should benefit. Financials have gained +4.24% on the year, but most of that has taken place post “Brexit” and specifically in the month of August. We would expect this trend to continue into the end of the year, barring poor economic data that would likely keep the Fed on hold into December or early 2017.
International Equity
International equities posted positive returns in August, led higher by risk assets such as Emerging Markets. The MSCI EM Index returned +2.52% during the period, while select EM countries such as Hong Kong’s Hang Seng Index (+5.23%) and China’s Shanghai Composite (+3.87%) outperformed.
Looking at the broader international developed equity space a different trend occurred. International developed equities, as measured by the MSCI EAFE Index rose a scant +0.10% on the month, while select countries and regions performed meaningfully better.
Eurozone stocks, as measured by the MSCI EMU Index, rose +1.36% during the month, and are up +6.59% so far this quarter. So much for “Brexit” fears. Moreover, the FTSE 100, a measure of the top 100 companies on the London Stock Exchange, rose +1.68% on the month, and has also shrugged off “Brexit” uncertainty by rising +5.17% during the quarter. Japanese equities, as measured by the Nikkei 225 Index, performed even better, gaining +1.99% during the month.
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Their quarter to date tally is an even stronger gain of +8.50%. From a sector standpoint, defensive sectors such as Utilities, Telecoms, and Healthcare underperformed during the month, as cyclical sectors such as Financials, Tech, and Industrials led the way.
Turning back to Emerging Markets, market sentiment remains strong in terms of asset flows into EM equity and fixed income funds as well as relative strength. As an asset class, believer’s in mean reversion are still waiting for EM’s day in the sun. Trailing 5-year annual performance for Emerging Markets has been a dismal -0.09% per annum.
This stands in stark contrast to the MSCI EAFE Index (+5.59% over the same time frame) and the S&P 500 (+14.66% annual return over the past 5-years). That return gap has potential to close as investors realize the diverging growth prospects of EM countries compared to Developed Market (DM) countries, meaning expectations are for EM to grow faster than DM moving forward. Couple that idea with attractive relative and absolute valuations within EM, and there’s still potential for more gains ahead.
However, EM equities remain one of the most volatile asset classes, and have rallied nearly +30% off their February lows, highlighting the potential for consolidation in the near term, especially with a Fed rate hike on deck. For longe
Fixed Income
Federal Reserve officials were out in full force during the month of August, highlighted by the Fed’s annual Jackson Hole symposium in Wyoming.
Fed Vice Chair Stanley Fischer was quick to iterate his hawkish tone, which was followed up by commentary from Fed Chair Janet Yellen, which highlighted the resiliency of the U.S. economy, and put the September FOMC meeting in focus. Looking at Fed Funds futures, which infer the market’s probability of a Fed rate hike, a notable shift has taken place since the end of the second quarter.
According to data compiled by Bloomberg and Strategas, the probability of a September rate hike stood at just 2% on June 30th , only to rise to 26% on August 23rd pre-Jackson Hole, and then to 42% on August 29th post-Jackson Hole. Those expectations stand at 32% as of this morning. Furthermore, it’s important to point out that the expectations for a November rate hike are largely in line with the September probability; however, December still remains a little better than a coin flip at 58%.
Coupled with the hawkish rhetoric from numerous Fed officials, it can be suggested that a decent August employment report, due out tomorrow, could be the final data point that causes the Fed to consider raising rates at its September 20-21 meeting. U.S. Treasury yields backed up to 1.62% at the end of August, rising +13 basis points from a month ago, as markets re-priced ahead of September’s FOMC meeting. The 2/10 Treasury spread continued to contract, dropping to 79bps in August, from 81bps in July.
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The back up in rates caused the ML U.S. Treasury/Agency Master Index to fall -0.55% during the month. Broadly speaking, the ML U.S. Broad Market Index fell -0.14%, highlighting the relative demand and attractiveness of investment grade corporate bonds, which continue to be the favorite when it comes to finding yield in the current environment. Investors continue to be forced to reach for yield by moving down the credit spectrum, as seen by the performance of the ML Corporate Master Index, ML U.S. High Yield Master II Index, and ML USD Emerging Markets Sovereign & Credit Index, which rose +0.27%, +2.23%, and +2.01%, respectively during the period.
Fixed income asset classes, especially the riskier credit sensitive areas, continue to post equity like returns year to date. U.S. High Yield and Dollar denominated EM debt have gained +14.58% and +16.46% apiece, while even higher quality fixed income asset classes have returned between +5-10% year to date. International sovereign debt with negative yields continues to pile up, reiterating the relative attractiveness of U.S. corporate debt and Treasuries. Even if the Fed decides to raise interest rates in September, there is likely a natural ceiling in the short term, as international investors would likely flock to higher yielding risk free assets in the U.S., keeping yields in check.
Alternative Investments
Alternative investments were a mixed bag in August, as changes in expectations for the Fed Funds rate impacted many asset classes from currencies, commodities, and real estate. Market based probabilities of a Fed rate hike in September changed meaningfully after many hawkish comments from Fed Vice Chair Stanley Fischer and Fed Chair Janet Yellen in Jackson Hole, WY. These changing expectations, well in place before Jackson Hole, caused a rally in the U.S. Dollar, as measured by the DXY Index, which gained +0.5% on the month.
The Dollar’s strength also caused gold to fall by -3.1% during the month to close at $1,309/ounce. Gold has remained in a consolidated trading range over the past three months after rallying more than +17.9% during the first four months of the year. Since then, the shiny metal has gained a mere +1.2%, highlighting the slowing momentum heading into September.
Real Estate Investment Trusts (REITs), as measured by the FTSE NAREIT All REIT Index, fell -3.5% on the month, as defensive yield oriented sectors felt the pain of the prospects for higher interest rates. It will be interesting to see the attention that REITs get in the coming weeks and months as Standard & Poor’s makes REITs the 11th GICS sector.
REITs have previously been lumped in with broader Financials, but will be separated on a stand alone basis moving forward. The strong Dollar also caused a mix reaction amongst the major commodities within the Bloomberg Commodity Index, which fell -1.8% during the month, even as West Texas Intermediate (WTI) crude oil rallied +7.5% during the month to close at $44.70/bbl.
Oil continues to be a topic of hot discussion – is the next major move up or down? While nobody has the answer to that question, a reasonable answer is that oil is likely to stay in a trading range of $40-$60/bbl for the foreseeable future as excess inventories and stockpiles are worked off.
This trading range, while broad based and general in nature, is largely defined by management commentary from large oil producers in the U.S. For example, we’ve heard the management team at Pioneer Natural Resources talk of profitability at $45/bbl oil at which they would add drilling rigs.
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WTI briefly traded above $50 earlier this summer, and we’ve seen the Baker Hughes rig count increase for weeks on end, albeit slowly off of a depressed base. This evidence most likely points to a price ceiling on oil in the short term, as higher prices naturally cause more oil production to come on line as companies can maintain profitability within the $40-$60 range.The currency market was fairly stable in August, with all eyes focused on the Federal Reserve’s upcoming decision on interest rates due in September. Interestingly, the Bank of Japan (BoJ) meets the same day, and could announce further stimulus as part of their strategic review.
So while the Summer months have been a lull in terms of currency movements, the Fall should be filled with multiple major central bank announcements that are likely to move currency and asset class prices alike.