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ECB comments trigger a swoon to end June

Brian Nick, Chief Investment Strategist, TIAA Investments


June 30, 2017

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Quote of the week

“Halfway down the stairs is a stair where I sit. There isn't any other stair quite like it.” —A.A. Milne (“Halfway Down”)

The Lead Story: Investors are ahead at halftime

Diversified investors should feel good about their portfolios heading into July. Bolstered by gains in corporate earnings, the large-cap S&P 500 Index is on pace for a first-half return of around 9%. Mid caps (+7.7%) and small caps (+5.1%) have also advanced year to date through June 29, according to respective Russell indexes. Thanks to improving economies and a tailwind courtesy of the declining dollar, international equities have done even better, with developed and emerging markets up 14.6% and 18.8% in U.S. dollars, respectively. 

While stocks have been rallying, the bond market has been wary. Expectations for subdued inflation and economic growth have pushed long-term yields down, while short-term yields have risen in line with the fed funds target rate. This has led to a flatter yield curve, with the gap between the yield on the 2-year and 10-year note shrinking to 89 basis points (0.89%) as of June 29, down from 125 basis points (1.25%) on January 1. Although a flat yield curve is often viewed as a harbinger of a recession, we see no such threat to U.S. economic growth in the near or medium term.

Brian Nick, Chief Investment Strategist, TIAA Investments

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Article Highlights

Against this backdrop, U.S. Treasuries have returned around 2% year to date through June 29. The ongoing search for yield has supported both high-yield and investment-grade corporate bonds, which have risen 4.9% and 3.9%, respectively. Emerging-market debt denominated in U.S. dollars (+5.2%) and local currencies (+9.1%) have been the star fixed-income performers.

During the week of July 3, look for “Time to earn it,” our second-half outlook for the global economy and financial markets.

In other news: The ECB shifts into damage-control mode

On June 27, European Central Bank (ECB) President Mario Draghi’s upbeat assessment of the Eurozone’s recovery fueled speculation that the ECB was poised to begin phasing out its quantitative easing policies. Markets interpreted his speech as hawkish, strengthening the euro versus the dollar and sending Eurozone government bond yields sharply higher.

The next day, other senior central bankers tried to steady nerves, seizing on Draghi’s remarks that the ECB will make only “gradual” adjustments to its aggressive monetary easing program and that the region still requires “considerable” support. Despite the ECB’s backpedaling, the euro closed at $1.14 on June 29, its highest level in more than a year, before weakening slightly on June 30. The yield on 10-year German government debt, which entered the week at 0.26%, rose to 0.46% by Friday. (Yield and price move in opposite directions.)

Fears over the prospect of less central bank stimulus weighed on Europe’s STOXX 600 Index, which fell 2.1% for the week (in euros). For U.S. investors, though, the euro’s rise cut that loss to just 0.26% in dollar terms.

Europe’s pain spread to U.S. stock and bond markets. For the week through June 29, the S&P 500 lost 0.7%, while the yield on the bellwether 10-year note, which began the week at 2.14%, closed at 2.27%. 

We are not alarmed by the market’s reaction. Long-term U.S. rates are still well below their March highs. Meanwhile, German bond yields remain near historical lows despite firmer signs of a strong economic recovery there. If and when the ECB formally decides to end its asset purchases, yields may well scale fresh peaks, akin to the “taper tantrum" in the U.S. Investors should recall that while U.S. stocks took some time to adjust to the end of the Fed’s bond-buying program in 2013, they eventually finished the year up nearly 30%. A similar announcement from the ECB could take place by year-end but is more likely to occur in 2018.

Below the fold: Consumers are careful, while inflation is MIA

Consumers were cautious in May, with real personal spending rising only 0.1%, as forecast . The personal savings rate rose to its best level (5.5%) since September as incomes increased 0.4%. However, this was due to an unexpected surge in investment income, not higher wages. Despite continued hiring, healthier balance sheets, elevated  confidence levels, and still-low interest rates, consumers have been reluctant to ramp up their spending in 2017. In our view, this spending data is still good enough to support GDP growth at a rate of close to 2.5% in the second quarter, up from the government’s third and final estimate of 1.4% in the first quarter.

Meanwhile, consumer confidence edged up in June after declining in May, according to The Conference Board’s index. While consumers believe the economy will continue expanding in the months ahead, they do not foresee the pace of growth accelerating.

Both headline and core inflation, which excludes food and energy costs, decelerated to 1.4% year over year in June. The Federal Reserve raised interest rates in June despite inflation's retreating further from its 2% target. More soft inflation readings over the summer would make a September rate hike even less likely. Indeed, we don’t expect another until December. The Fed trusts that low unemployment is an indicator of a tight labor market, which will eventually result in stronger wage growth.

Back page: Sleepless in Seattle—when a rising minimum wage leads to job losses

A record 19 states are poised to raise their minimum wages in 2017, with some of the nation’s more expensive cities (such as New York, San Francisco, Los Angeles, and Seattle) scheduled to boost the wage to $15/hour, in phases. This is twice the federal minimum of $7.25, a figure unchanged since 2009. 

On April 1, 2015, the National Bureau of Economic Research (NBER) reported that Seattle’s first increase, which required employers to pay $11/hour, up from $9.47/hour (a 16% gain), had little impact on total payrolls. The result of this study, which matched that of many recent ones, showed that employers offset this higher cost by reducing workers’ hours and raising prices, among other things.   

During the week, the NBER examined the effects of Seattle’s second hike, to $13/hour, which took place on January 1, 2016. Here, the results were noteworthy. Researchers noted a 9.4% drop in hours worked and, crucially, a 6.8% decline in the number of low-income jobs. 

This conclusion follows the basic law of supply and demand: as the price of labor reaches a certain point, employers will decrease their demand for workers. The findings of the Seattle experiment, while not surprising, may serve as a warning for other cities as they, too, seek to balance the need to raise wages with keeping payrolls intact.