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In March, U.S. equities came in like a lion and went out with lots of questions

Brian Nick, Chief Investment Strategist, TIAA Investments


March 31, 2017

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Quote of the week

"He had high hopes, he had high hopes, he had high apple pie, in the sky hopes…” –Frank Sinatra

The Lead Story: Approaching euphoria

Nowadays, a lot of people are walking with an extra spring in their step. Consumers, for example, haven’t felt this chipper since 2000, according to The Conference Board’s latest confidence index. CEOs expect to see near-term increases in sales, employment, and capital spending as they continue to harbor hopes that President Donald Trump will enact pro-growth policies to jumpstart the economy. Small business sentiment, meanwhile, remains near a 43-year high, as measured by the NFIB. And homebuilders, confident that a Trump executive order to relax environmental regulations will spur the issuance of building permits, pushed the NAHB index to its best level since 2005.

Brian Nick, Chief Investment Strategist, TIAA Investments

Brian Nick - 140px

Article Highlights

In the Eurozone, business conditions in the region’s manufacturing and services sectors appear to be improving: Markit’s “flash” (preliminary) Composite Purchasing Managers’ Index (PMI) soared in March to a near six-year high, bolstered by better-than-expected results from Germany and France, the currency bloc’s two-largest economies.

Focusing on this so-called “soft” data—reports based on sentiment rather than on “hard” numbers derived from actual economic activity—helped power global equities in the past week and for the first quarter as a whole. The S&P 500 Index finished the three-month period with a gain of about 6.1%. Europe’s STOXX 600 Index also produced strong results, with a robust 7.8% return for the quarter (in U.S. dollar terms).

In other news: Still far from utopia

Despite posting a positive return for the sixth consecutive quarter, the S&P 500 wobbled a bit in March after starting the month at a record high. Investors began to focus on sluggish hard data, including disappointing retail sales, consumer spending, and business investment. As signs began to emerge that the U.S. economy might not accelerate as fast as markets had hoped, equities began to lose some appeal.

On the other side of the Atlantic, investors have remained concerned about political risk in France and elsewhere, as rising nationalist sentiment seems to threaten the fabric of the European project, including the euro. In our view, though, this risk appears to be overly priced into equity markets, keeping valuations low and making European stocks one of our preferred asset classes.

A potential European equity wild card has been the prospect of a more hawkish European Central Bank (ECB). However, inflation in the Eurozone cooled more than expected in March—a welcome sign for investors concerned that lingering effects from the year-on-year increase in oil prices would make it difficult for the ECB to maintain its accommodative monetary policy.

While a good deal of optimism has already been “baked into” equity prices, the U.S. Treasury market, as it often does, offers a more sober picture about the direction of U.S. economic growth. The rising yields that frequently accompany a strengthening economy have not materialized so far. For example, the bellwether 10-year U.S. Treasury closed the week at 2.40%, about where it started the week and the year. Moreover, the yield curve has flattened in the last few weeks, typically a sign that bond markets have become somewhat more skeptical of faster economic growth.

Elsewhere in fixed-income markets, returns for most non-Treasury “spread sectors” were flat to modestly negative for the week through March 30. Boosted by rising oil prices, high-yield corporate bonds outperformed by a wide margin, bringing their return for the first quarter to 2.60%.

Overall, we think spread products are somewhat richly priced but not unreasonably so. With that in mind, we believe it’s prudent to pay slightly higher prices for better-quality high-yield corporate bonds, leveraged loans, and asset-backed securities. We also see opportunities to selectively add emerging-market corporate bonds, which have produced attractive risk-adjusted returns over the past few months.

Current updates to the week’s market results are available here.

Below the fold: Brexit officially begins

On March 29, British Prime Minister Theresa May formally began the process of leaving the European Union (EU). After spending more than a decade trying to join the EU, the U.K. now has two years to complete the “divorce.”  The EU has already made clear it wishes to settle issues of disentanglement relating to citizenry, borders, and budgets before moving on to trade.

In the U.S., some hard data trickled in. Among the week’s reports:

  • Consumer spending edged up 0.1% in February, the smallest increase in six months, following January’s unrevised 0.2% rise. The slowdown in spending took place despite a healthy 0.4% improvement in personal income.
  • Inflation, as measured by the Fed’s preferred inflation barometer (the PCE index), rose 0.1% in February, bringing the year-over-year increase to 2.1%, just above the Federal Reserve’s 2% target. The “core” PCE index, which excludes food and energy costs, climbed 0.2% in February and 1.8% compared to a year ago.
  • The government’s third and final estimate of fourth-quarter GDP growth showed a slightly faster pace than previously reported, 2.1% versus 1.9%. All of the upward revision came from stronger personal consumption, while net exports were a bigger drag than they’d been in earlier estimates. With consumer confidence also on the rise, the U.S. economy appears to have entered 2017 well supported by households.

Back page: The U.S. economy may decelerate in Q1

While favorable personal consumption helped boost GDP growth in the fourth quarter of 2016, the more recent trend has not been encouraging. In February, real consumer spending fell for the second straight month, the first time this has happened since 2011. This could be the result of a temporary rise in inflation (real spending tends to fall as inflation increases), but it will almost certainly lead to a weak first-quarter GDP print, barring a miraculous consumer comeback in March.

The Atlanta Fed GDPNow forecast is tracking first-quarter growth at 0.9%, taking the lack of evidence of real consumption more seriously than the euphoric but “soft” consumer sentiment surveys. At the same time, people have raised their savings rates in 2017, a curious dynamic. (Generally, consumers tend to save less and spend more if they are optimistic about the economy.)

Bottom line: When the initial estimate of first-quarter GDP is released on April 28, we’re expecting growth in the 1% to 1.5% range, well below the economy’s fourth-quarter 2.1% pace. Our hope is that the slowdown reflects a temporary lack of utilities spending during a warm winter, rather than evidence of slowing demand.