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Markets have a lot to digest as the second quarter gets underway

Brian Nick, Chief Investment Strategist, TIAA Investments


April 7, 2017

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Quote of the week

"In the state of nature, profit is the measure of right.” – Thomas Hobbes, 16th century English philosopher

The Lead Story: A case of good news/bad news for corporate earnings and U.S. equities

Let’s start with a positive: first-quarter earnings are projected to grow as much as 10% versus a year ago, their fastest pace since 2011. Now, the negative. Equity markets may yawn in response to this solid performance. In our view, the S&P 500 has already priced in a strong pickup in earnings—not just for the first quarter but for the remainder of 2017—reflecting confidence that some form of corporate tax relief and regulatory reform will be rolled out in the second half of the year. Put another way, the market is already way ahead of earnings.

So with corporate earnings expansion turning positive again following the end of an oil-driven recession in profits, some of the first-quarter numbers will undoubtedly look very good. But that’s what the market expects. If earnings don’t meet that 8%-10% growth threshold, stocks could relinquish their post-election gains.

Brian Nick, Chief Investment Strategist, TIAA Investments

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Article Highlights

With earnings season about to kick off, investors already have a lot on their minds. The second quarter began with several potential market-moving events, including President Donald Trump’s two-day meeting with President Xi Jinping of China, the release of the Federal Reserve’s March minutes on April 6, and the Labor Department’s jobs report for March the following day. Adding to the uncertainty was news that late on April 6, the U.S. launched missile strikes against a Syrian military base in response to Syria’s use of chemical weapons earlier in the week.

Financial markets took the week’s news in stride. Both the S&P 500 and Europe’s STOXX 600 Index (in U.S. dollar terms) fell slightly. In fixed-income markets, the yield on the bellwether 10-year U.S. Treasury note closed at 2.38% on April 7, just below where it began the week. (Yield and price move in opposite directions.) Returns for non-Treasury “spread sectors” were solid across the board for the week through April 6, with high-yield corporate bonds benefiting from their largest inflows in three months.

The ability of markets to shake off geopolitical turmoil, whether from civil wars in the Middle East or terrorist attacks in the U.S. and Europe, has been remarkable in recent years. We are monitoring the risk of escalation in the Syrian conflict but continue to see little risk of it having a dramatic effect on global asset prices. Still, it’s yet another wild card—along with the U.S. legislative agenda, the possibility of a government shutdown, and the upcoming French elections—for the markets to consider.

In other news: A “bad headline/good story” March jobs report

The U.S. labor market generated a far-below-consensus 98,000 jobs, the smallest one-month increase since May 2016. Also, employment gains for January and February were reduced by a combined 38,000. Headlines will likely focus on these downbeat figures. But there’s also a three-part good story: the unemployment rate fell to 4.5% from 4.7%, meaning the U.S. economy has, in all likelihood, reached full employment. Moreover, the U-6 “underemployment rate,” which includes discouraged workers and part-time employees unable to find full-time jobs, dropped to 8.9%, its lowest level since 2007. Lastly, wage growth for March (+0.2%) met expectations, bringing the annual increase to 2.7%, and February’s gain was revised upward. With new unemployment claims dropping sharply (see “Below the Fold,” below) and job openings near all-time highs, it’s only a matter of time until wage growth breaches the 3% mark.

Some commentators believe that this lackluster jobs report could slow the Fed’s pace of rate hikes, but in our view, a single month of disappointing payroll growth will not be enough. Actually, this report contains at least as much data to support the hawks (those who favor tightening) as it does the doves. Therefore, we still expect a 25-basis-point (0.25%) hike when the Fed meets on June 13-14.

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

Below the fold: An additional sign of a tight job market

In addition to the March jobs report, this week’s U.S. data releases included further evidence of a tightening labor market, while other economic data was mixed. Among the week’s key releases:

  • Weekly jobless claims plunged by 25,000, their largest drop in nearly two years, to 234,000. The four-week moving average, considered a better measure of labor market trends as it irons out week-to-week volatility, also fell, by 4,500, to 250,000.
  • Factory orders rose 1% in February, their third straight month of gains. In another encouraging sign, January’s orders were revised higher.
  • U.S. manufacturing activity, meanwhile, slipped to 57.2 in March but remained well above the 50 mark separating expansion from contraction, according to the Purchasing Managers Index published by the Institute for Supply Management (ISM).
  • Similarly, the pace of service-sector activity slowed but remained robust, with the ISM non-manufacturing index coming in at 55.2 in March.
  • Auto sales, which were expected to snap back after dropping the previous two months, declined 1.6% in March compared to a year ago.

Back page: The Fed prepares to roll out the roll off

Minutes from the Fed’s March 14-15 meeting, released on April 6, indicated that policymakers expect to begin the process of paring back the Fed’s $4.5 trillion portfolio later this year. The Fed added more than $3 trillion to its balance sheet, mostly in the form of U.S. Treasuries and mortgage-backed securities, as part of its quantitative easing programs designed to lower yields and stimulate the economy. Because the Fed currently reinvests the principal from maturing bonds, it needs to tread carefully and communicate its intentions clearly. Rather than sell securities back into the market, which could result in bond market panic, it will likely opt for a passive and predictable approach by allowing maturing proceeds to roll off without replacement.

Fed officials also weighed in on current equity market multiples, a common theme these days among investors. Several members—the minutes don’t specify which ones—viewed equity prices as “quite high relative to standard valuation measures.” And a few noted that the post-election rally may be more the result of expectations for corporate tax cuts or higher risk tolerance rather than of a stronger economic growth. We’re inclined to agree.