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U.S. equities overcome both the Fed and volatile Tech stocks

Brian Nick, Chief Investment Strategist, TIAA Investments


June 16, 2017

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Quote of the week

“If you don’t like how the table is set, turn over the table.” — Frank Underwood, from the series “House of Cards”

The Lead Story: Signs of laboring from the U.S. labor market

May’s employment data showed a softening jobs market. Payroll growth totaled 138,000 compared to the consensus forecast of 182,000.  Downward revisions to March and April brought the total “miss” to 110,000 fewer jobs than expected. The unemployment rate continued to fall, to 4.3%, from 4.4% in April, largely due to a drop in the labor force participation rate.  On the bright side, the so-called “underemployment rate” ticked down to 8.4% from 8.6%, a sign that more of those who want to work are able to find jobs.

Brian Nick, Chief Investment Strategist, TIAA Investments

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Article Highlights

The U.S. economy is not growing so quickly that it needs the Fed to step on the policy brakes, nor does it still require extraordinary monetary stimulus to keep going. Although recent data releases have not been stellar, we expect second-quarter GDP of 2.5% to 3%, up from the first quarter’s paltry 1.2% gain. And let’s not forget that while U.S. interest rates are higher than those in nearly all other developed countries, they remain near historic lows. 

Another factor in the “time to tighten” column is the labor market’s strength, May’s disappointing payroll report notwithstanding. With the jobless rate dipping to 4.3%, a 16-year low, the Fed has achieved full employment, one part of its dual mandate. But we would not be surprised by sub 4% unemployment if the labor force participation rate also declines and the economy grows at a reasonable clip. 

Not that we’re advocating a “hawkier” Fed, but should policymakers consider accelerating the pace of rate hikes? Those relying on a fixed-income savings would likely approve. Since the Fed began its quantitative easing (QE) program in late 2008, the average “real” (i.e., after-inflation) yield on the bellwether 10-year U.S. Treasury has dropped and now sits at just 0.75%, a far cry from the average real yield of 2.75% during the 30+ years prior to QE.

However, raising interest rates too quickly can choke off economic growth, as European Central Bank (ECB) President Mario Draghi discovered the hard way. The ECB lifted rates twice in 2011, thwarting a nascent recovery and plunging the Eurozone into a double-dip recession that it is still struggling to overcome.

Furthermore, the U.S. economy is not exhibiting signs of overheating. Quite the opposite, in fact. The Consumer Price Index dipped 0.1% in May, pulling down its year-on-year increase to 1.9%, below April’s 2.2% pace. Stripping out food and energy prices, so-called “core inflation” edged up just 0.1% in May, leaving its annual rise at 1.7%, under the Fed’s 2% target. The Fed, though, is betting that labor market tightness will translate to higher wages and, eventually, greater inflation.

In other news: U.S. stocks advance despite Tech volatility

In an up-and-down week, the S&P 500 eked out a small gain; Europe’s STOXX 600 lurched lower. Lately, U.S. stocks have wobbled due to volatility in the Technology sector, which has surged 18% year-to-date through June 15. While there have been few signs of a downward revision to the sector’s expected earnings, investors may be getting skittish about owning select mega-cap names after their meteoric share price appreciation this year.

Notably, the rotation out of Tech has coincided with a pronounced drop in U.S. interest rates, which tends to lead markets toward more defensive sectors like Utilities. Tech remains one of our favored sectors for the balance of the year given accelerating global growth, strong earnings appreciation, and still-reasonable valuations.

In fixed-income markets, U.S. Treasuries rallied for the week. The yield on the bellwether 10-year note closed at 2.15% on June 16, pulled down by soft inflation and retail sales data. (Yield and price move in opposite directions.) Investors reacted little to the Fed’s latest rate increase and talk of balance sheet reduction. We expect the Fed to raise rates just once more this year, most likely in December.

Among non-Treasury sectors, a weaker dollar, solid technical factors, and significant fund flows continued to support emerging-market debt. Floating-rate loans also garnered inflows, as investors sought their higher quality (versus high-yield corporate bonds) and ability to provide a measure of protection in rising-rate markets. Falling oil prices failed to derail high-yield corporates, whose modest gain for the week through June 15 improved their year-to-date return to 5.1%.

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

Below the fold: Exuberance has given way to mere confidence

Since surging to multi-year highs following the November election, some monthly sentiment surveys have slipped. Among the week’s releases:

  • Small-business sentiment in May matched April’s strong performance, according to the NFIB index. While owners overall are still optimistic that President Trump will enact tax and health-care reform, many have been struggling to find enough qualified workers.
  • Homebuilder confidence weakened in May but remained solid. Builders also expressed frustration over a shortage of skilled labor.
  • Consumer sentiment slid to 94.5, well below forecasts, according to June’s preliminary reading of the University of Michigan index.
  • In a stark reversal from April’s 0.4% jump, retail sales fell 0.3% in May, their biggest drop in 16 months. Year-over-year, though, sales are up a respectable 3.9%.
  • Housing starts decreased in May for the third month in a row, while building permits, a forward-looking indicator, declined to their lowest level in 13 months.

Back page: The good, the bad, and the ugly of consumer debt

In March, Americans reached a new milestone: collective household debt hit $12.73 trillion, surpassing 2008’s peak of $12.68 trillion. Although recent articles have suggested we’re a nation of spendthrifts, is this level of debt good, bad, or downright ugly?

The good news is that because of tougher underwriting standards on mortgages, borrowers’ credit scores are higher than they’ve been in the past. Moreover, debt service—the ratio of debt payments to disposable income—on the $8.6 trillion of housing loans has plunged to 4.4%, a 37-year low. 

The increase in the number of subprime borrowers—those with credit scores under 620—taking out auto loans sounds bad. (Auto loans tend to have looser underwriting standards.) Balances of these high-risk customers have surpassed their pre-recession peak, and delinquencies on car loan payments have jumped versus last year. However, the improving U.S. economy has also lifted the total number of loans. So as a percentage, there are fewer high-risk customers today than there were prior to the financial crisis.

With student loans, things get a bit ugly. The average student loan, $37,000, has more than doubled since 2008. According to a study by the Life Insurance and Market Research Association (LIMRA), outstanding student loan debt of $30,000 at graduation can reduce retirement savings by as much as $325,000. Such a reduction has serious long-term repercussions. 

Broadly speaking, we see no reason to panic. In addition to the encouraging debt-service number, household debt is around 79% of U.S. GDP, a 15-year low. But further Fed rate hikes may eventually make paying off consumer loans more expensive and place greater stress on personal balance sheets overall. That’s a dynamic worth watching.