The backward-looking nature of most economic data reports implies that the anticipated stimulative effects of the recent Tax Cuts and Jobs Act of 2017 have yet to be realized and shouldn’t be looked for in current readings.
That’s a good thing given the tepid nature of the data we’ve seen over the past month. While hardly dismal, the data doesn’t support the elevated equity valuations we currently see in the U.S. market.
The second release on Q4 GDP showed the economy expanding at a +2.5% SAAR, down slightly from the initial report of +2.6% growth. The aforementioned fiscal stimulus provided by tax cuts will likely not work its way into the data until later in Q2 or Q3. Our bet at this point is for GDP growth north of +3% as we approach the end of the year.
The accuracy of this prognostication depends a lot on the pace of Federal Reserve rate hikes. Any deviation from the plan for 2 to 3 hikes will likely make this +3% target more difficult to achieve.
The Unemployment Rate for January came in at 4.1%, consistent with expectations and the prior month’s reading, as 200,000 new jobs were created, slightly ahead of surveys. Average hourly earnings for the month rose a better than expected +0.3% and are now up +2.9% YoY. Initial jobless claims averaged 220,000 in February.
Hints of inflation have been the proverbial canary in the coal mine for this long-running bond bull market. With the debate on whether broad price inflation can exist in this era of the internet still ongoing, it will take
meaningful and persistent inflationary signals to change bond investor behavior. On top of the wage growth mentioned above, CPI for January surged +0.5% (versus expectations for +0.3% growth) while PPI came in consistent with pre-market surveys at +0.4% MoM. Although the PCE Deflator remains somewhat lackluster at +1.7%, CPI at +2.1% YoY and PPI up +2.7% YoY signals something’s in the air.
New Fed Chair Jerome Powell testified before the House Financial Services Committee this week and opened the door to the potential for a fourth rate hike in 2018. The bond market continues to take the under on this bet and as we’ve cautioned numerous times in the past, it rarely pays to bet against the Fed.
Domestic Equity Outlook
U.S. equity markets hit a speed bump in February, ending a 15-month streak of positive monthly returns on the benchmark S&P 500 index, which fell -3.69% on the month. Volatility surged, and the S&P 500 had 12 market sessions with more than a +/- 1% move, the most in more than two years. February 2018 was very reminiscent of February 2016 (the last time U.S. equity markets hit a rough patch), except instead of oil prices collapsing much can be blamed on rising interest rates (10-year Treasury yields jumped as high as 2.95% during the month) and the potential regime change ushered in by new Fed Chair Powell.
February’s losses on the S&P 500 come after the index rose +5.72% in January, bringing year to date gains to +1.83%. Small- and Mid-Caps fared similarly, falling -3.88% and -4.43% respectively on the month.
For those asking “what has changed” from 2017 to 2018, the easy answer is “not much.” Technology stocks such as Facebook, Amazon, Apple, Netflix, Microsoft, and Google continue to power the market, and remain responsible for an outsized portions of its returns, both in 2017 and thus far in 2018.
On the month, the S&P 500 Technology sector returned +0.10%, echoing the positive sentiment that continues to buoy Technology shares, which are up +7.73% year to date. Financials continue to hold up well, specifically the Banks, as the yield curve has shifted significantly YTD. Financials returned -2.78% on the month, with Banks not far behind (-2.73%). Energy was the worst performing sector, losing -10.82% on the month, and remains the only sector with a negative 5-year annualized return (-0.36%).
As yields rose, interest rate sensitive sectors such as Consumer Staples, Telecoms, Real Estate Investment Trusts (REITs), and Utilities suffered, with each sector losing -7.76%, -7.06%, -6.71%, and -3.86%,
respectively on the month. Year to date, each sector has lost more than -6%. With expectations for higher interest rates in 2018, rate sensitive sectors will likely face additional headwinds in months ahead.
From a style standpoint, Growth stocks, as measured by the S&P 500/Citi Growth Index, outperformed Value stocks, as measured by the S&P 500/Citi Value Index, by nearly +350bps, reiterating strong Technology oriented sentiment. February was also a strong showing for single factors, with both the MSCI Momentum and Quality indices (not shown) outperforming the broader S&P 500 by a sizeable margin.
International Equity Outlook
International equities were also hit hard in February, suffering from a global equity rout that left few parts of the global equity universe unscathed. Developed International equities, as measured by the MSCI EAFE Index, lost -4.48% on the month. Emerging Markets performed similarly, with the MSCI EM Index losing -4.63% on the month. From a regional perspective, the Eurozone underperformed, with the MSCI EMU Index shedding -3.74% in EUR terms, but -5.34% in USD terms, as the Euro weakened slightly versus the U.S. Dollar during February.
At the individual country level, China was especially hit hard, with the Shanghai Composite Index giving back -6.36% (CNY), while the Hang Seng Index in Hong Kong was not far behind, losing -6.0% (HKD). The United Kingdom continued its economic slump, with the FTSE 100 Index losing – 3.39% in GBP terms, plus another -2.71% in currency terms, for a total return of -6.1% to U.S. based investors. Japan fared better, with the benchmark Nikkei 225 Index losing -4.41% in JPY terms, while strength in the Yen buoyed U.S. based investors (+2.36%) for a total return of -2.05% on the month in USD terms.
From a sector standpoint, all 11 international sectors finished meaningfully in the red, posting losses of -3.33% (Consumer Discretionary) to -6.95% (REITs) on the month. Strength in Technology stocks was nowhere to be found, with the MSCI ACWI ex. U.S. Technology sector losing -4.04%, in sharp contrast to its U.S. brethren. As we’ve noted in the past, the MSCI EM sector is highly concentrated at the sector level (Technology, 27.6%), and the top five names in the index (Tencent, Alibaba, Samsung, Taiwan Semiconductor, Naspers) make up 19.38%.
As many of those stocks have doubled in price and become more expensive, lesser favored sectors playing on consumption driven themes, countries that have been out of favor (such as Brazil) and regions that are more localized (less correlated with the global economy) in Southeast Asia look more attractive. From a factor standpoint, Value and Quality remain favorable characteristics to ride out market volatility and add exposure within the EM space.
Looking ahead, all eyes are on Italian elections scheduled for Sunday, where the populist 5 Star Movement leads in the latest polls; however, without a majority. The wildcard will be whether or not the group has a strong showing amongst undecided voters, similar to Brexit and the French elections of years past.
Fixed Income Outlook
New Federal Reserve Chairman Jerome Powell provided a relatively bullish economic outlook in his first outing testifying before the House Financial Services Committee on February 27th, and the markets reacted with the USD strengthening, interest rates moving a bit higher, and the likelihood of a fourth rate hike in 2018 increasing substantially. He will provide additional testimony before the Senate Banking Committee today. Expectations are that Chairman Powell may present a more balanced view on the economy to avoid further market impact, having gained experience from his prior performance.
Interest rates continue to creep higher. The 2.25% yield on the two year Treasury bond has risen to a level that hasn’t been seen since 2008, while the ten year Treasury has flirted with the 3% level last breached in late 2013.
Credit spreads widened a bit along with the equity market turmoil, but do not appear to present a compelling value opportunity as they are still hovering near historically tight levels. Price impact of spread widening can be limited by keeping portfolio credit exposure within the short/intermediate maturity range. A 50 basis point increase in spread will have a roughly -0.9% price impact on a 2 year bond, a -2.3% price impact on a 5 year bond, and a -3.8% price impact on a 10 year bond.
Municipal bond prices have exhibited strength, with an assist from the technical support provided by the decline in issuance due to restrictions in the tax reform bill. A typical 10 year Aaa muni yields 87% of the current 10 year Treasury yield. This is below the recent average of 95%, but roughly in line with the longer term average. There is some talk of relaxing the restriction on the pre-refunding of outstanding bonds, which would significantly increase the amount of issuance coming to market, easing the supply drought.
There has been some concern that during the recent equity market sell off, bonds also sold off, failing to exhibit their traditional inverse price performance (stocks down=bonds up, and vice versa). While it is unusual, bonds continue to provide a portfolio volatility buffer (they did not fall in price anywhere near as much as equities), and longer term, it is unlikely that this historical performance relationship has dissolved. Higher credit quality portfolios have held up better during the turmoil, due to their insulation from excessive credit spread widening.
Alternative Investments Outlook
Alternative investments fared poorly in February, led by declines in commodities, real estate, and gold. Commodities, as measured by the Bloomberg Commodities Index, lost -1.8% on the month, helped lower by a pull back in oil prices.
West Texas Intermediate (WTI) crude oil lost more than $3/barrel, or -4.8%, to close below $62/barrel on the month.
Oil prices have come under pressure as inventories continue to undergo a supply and demand rebalance. U.S. oil production continues to hover at levels above 10 million barrels per day, levels not seen in decades. With energy companies largely profitable at $60/bbl oil prices, additional supply is likely to continue coming on line in 2018. The key question remains how much global demand rises, and how much supply comes offline from Venezuela and countries in the Middle East. These dynamics should likely keep oil prices range bound in the $55-70/bbl range this year, absent a shock to the market.
Interest rates rose sharply intra-month, with the benchmark 10-Year U.S. Treasury yield eclipsing 2.95%, before retreating. According to data from CME Group, market expectations for a fourth interest rate hike this year topped 35%, after Fed Chair Powell’s congressional testimony at the beginning of the week. With signs of a pick up in inflation firming and the likelihood of higher interest rates all but certain, bond prices are due to come under pressure.
Weakness in interest rate sensitive equities was apparent in February, with the FTSE NAREIT All REIT Index losing -7.2% on the month. With the back up in rates, and the expectations for a 4th interest rate hike increasing, the Dollar, as measured by the DXY Index rose +1.7% on the month. The Dollar’s strength, coupled with higher real yields, helped push Gold -2.0% lower on the month, to close at $1,318/ounce.
The strength in the Dollar, taken together with weaker than expected data from the Eurozone, helped put downward pressure on the Euro, which weakened to $1.22 USD/EUR on the month. Other likely qualitative contributors to Euro weakness are uncertainty from the upcoming Italian elections Sunday and repatriated cash coming back to the U.S. from abroad (including Europe). Furthermore, the expectation for NAFTA negotiations to pick up in March has put downward pressure on the Canadian Loonie (and the Mexican Peso), which weakened from $1.23 CAD/USD to $1.28 CAD/USD in February. Weaker than expected global economic data from all countries was also a likely contributor to respective currency weakness.
This article was written by Nottingham Advisors, a participant in the ETF Strategist Channel.