Brian Nick, Chief Investment Strategist, TIAA Investments
July 21, 2017
“The dollar may be our currency, but it’s your problem.” John Connally, U.S. Treasury Secretary (1971-1972)
In early January, the U.S. dollar surged to a 14-year high against a basket of currencies, fueled by a series of strong economic data releases and expectations of a faster pace of interest-rate increases from the Federal Reserve. Since then, the dollar has steadily declined, reaching a 10-month low on July 20. A number of factors have triggered its fall, including better- than-expected growth outside the U.S.—especially in the Eurozone and China—and the increased likelihood that the Fed will raise interest rates only gradually in the coming quarters.
In our view, though, U.S. political risk has emerged as the dollar’s primary barometer. Indeed, this element has affected the currency more than either equities or fixed income. For example, the dollar has tended to weaken on days when the Russia investigations make headlines.
Brian Nick, Chief Investment Strategist, TIAA Investments
But is the dollar’s drop necessarily a bad thing? U.S.-based investors don’t think so. This year’s large gap between domestic and foreign asset returns is largely a product of dollar weakening. Moreover, rising foreign currencies give global central banks greater scope to ease monetary policy. Consider the European Central Bank (ECB). Thanks to the stronger euro, the ECB can continue to buy bonds in the open market without igniting inflation. (Admittedly, though, the ECB would like prices to rise a bit further from their current levels.) Also, a weaker dollar makes it easier for foreign companies to repay their dollar-denominated debt.
Despite assurances from ECB President Mario Draghi that he is in no hurry to rein in the ECB’s monetary easing program, late in the week the euro hit a two-year high of $1.168—already above our year-end target of $1.15.
So far, so good for U.S. corporate balance sheets. Although only 20% of S&P 500 companies have reported their second-quarter earnings, over 75% have outstripped expectations for both revenues and profits, with our three preferred sectors—Information Technology, Consumer Discretionary, and Financials—outperforming the most. Thanks to a dismal second quarter of 2016, Energy companies, which have yet to report, should generate the largest year-on-year earnings increase by far.
During the week, there was little for equity markets to digest given the limited number of earnings reports, a light economic data docket (see below), and the Fed in its customary blackout phase prior to its next meeting (July 25-26). The S&P 500 gained about 0.5% for the week, with Information Technology names providing a big boost. Year to date through July 20, Tech has surged nearly 24%, more than doubling the S&P 500’s 11.7% advance. For the week, Europe’s STOXX 600 posted a modest gain in U.S. dollar terms but is up a hefty 19.2% year to date.
In fixed-income markets, the subdued inflation outlook, partly due to slow wage growth, continues to restrain Treasury yields, as do concerns that President Trump’s legislative agenda has wilted in the sweltering summer heat. The yield on the bellwether 10-year note, which moves in the opposite direction of its price, closed at 2.24% on July 21 after beginning the week at 2.33%. For the week through July 20, Treasuries returned 0.4%.
Non-Treasury sectors also performed well, led by investment-grade and high-yield corporate bonds, which both returned 0.6% for the week through July 20. Despite having already delivered robust year-to-date returns, emerging-market debt (+11.3% for local currency bonds, +5.9% for U.S. dollar credits) is still attracting positive fund flows.
Markets paid little heed to the past week’s mixed housing reports and signs that the U.S. economy is chugging along. Among the releases:
For the past three months, the S&P 500 and the yield on the 10-year Treasury have been moving in opposite directions (i.e., their correlation has been declining). In large part, that’s because U.S. equities remain more bullish about the prospects for U.S. economic growth, while bonds have taken note of weaker data and the lack of progress on policy changes. We don’t expect these divergent perspectives to continue, because over long periods of time, stock prices and yields tend to move in the same direction. (Broadly speaking, a stronger economy is accompanied by both higher stock prices and rising yields, while a weakening economy tends to see both lower stock prices and declining yields.)
Of course, correlation doesn’t equal causation. Consider the “Skyscraper Index,” which claims to demonstrate a connection between business downturns and skyscraper construction. For example, the completion of Dubai’s 2,717 foot Burj Khalifa roughly coincided with the beginning of the global financial crisis. Before that, erecting the 1,671 foot tall Taipei 101 took place during the recession in the early 2000s. The index looks at similar instances dating back to the 1800s. While this relationship may be intriguing, there’s clearly no empirical evidence supporting the notion that the height of buildings can predict the flow of business cycles.
Investors should keep this “causation/correlation” message in mind before predicting, say, how a particular stock or fund will perform if a jobs report exceeds or undercuts expectations, even if they’ve been right before. That winning bet may have been just luck or a coincidence, nothing more. In our view, that’s not a smart way to build a portfolio.
© 2017 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA), 730 Third Avenue, New York, NY 10017