A Friday rally nearly salvages an otherwise lost week for U.S. equities

Brian Nick

The past week’s market highlights:

Quote of the week:

“If we keep doing what we’re doing, we’re going to keep getting what we’re getting.”
– Steven Covey

As part of our new format, we are presenting our featured weekly topics in the context of the major themes listed below from the Nuveen Q2 Outlook:
  • U.S. economy: Late cycle has arrived.
  • Global economy: There’s still good news out there.
  • Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
  • Fixed income: Bond markets offer few places to run, even fewer places to hide.
  • Equities: The bull market’s not over, but expect plenty more volatility.
  • Asset allocation: Valuations are no longer at extremes.

U.S. economy: For now, the Fed’s message is “Keep doing what you’re doing”

The U.S. economy added 164,000 jobs in April, a solid increase but shy of consensus forecasts of 194,000. The headline-grabber for this report was the unemployment rate, which fell to an 18-year low of 3.9% (from 4.1% in March). We continue to anticipate that rising employment will lead to stronger wage growth. But the April report showed year-over-year growth in average hourly earnings at a relatively muted 2.6%, with downward revisions to wage gains in February and March. Despite the lukewarm wage data, the current combination of historically low unemployment and still-strong economic data provides the Fed with further runway for normalizing rates.
Broadly, the economy remains healthy, notwithstanding some recent softening in certain indicators. Surveys of manufacturing and service-sector activity published by the Institute for Supply Management (ISM), for example, slowed in April, albeit from extraordinarily high levels. Indeed, the monthly ISM indexes have been in continual expansion mode for over eight years. Managers surveyed have noted rising prices over the past two years, with costs continuing to tick higher each month in 2018. Higher inflation could conceivably justify upward revisions to the Fed’s trajectory of rate hikes.
Overall, recent economic data suggests the U.S. is still in “Goldilocks” mode, and—for now—the Fed appears comfortable with this view. After laying out a more hawkish blueprint in March, Chair Jerome Powell and his fellow Fed policymakers declined to raise rates on May 2. Instead, as expected, they seemed satisfied to let the markets continue digesting the expectation of future hikes.
They also reiterated their intent to remain measured and data-dependent, conveying a willingness to accept some short-term inflation fluctuations as long as overall economic activity stays at a moderate pace.

With unemployment at multi-year lows and inflation just a hair below the stated 2% target, the Fed has all but fulfilled its dual mandate. So what happens next? Futures markets are pricing in a 97% probability of a June rate hike. We agree and continue to expect three more rate increases in 2018.

U.S. economy: Dollar bulls say “Now it’s our turn”

The puzzling U.S. dollar weakness in the first quarter has finally started to reverse.
Expectations for a steady series of Fed rate hikes pushed up the yield on the 2-year U.S. Treasury to 2.27% by the end of March. Concurrently, growing inflation concerns and forecasts for an increase in Treasury issuance to fund tax cuts and deficit spending lifted the yield on the bellwether 10-year security to 2.74%. In contrast, short-term interest rates in Europe remained negative, with investors continuing to pay for the privilege of lending money to the German government; the 2-year schatz closed at -0.59% on March 29. Longer-term yields were only marginally better, as the 10-year German bund offered a scant 0.50% by the end of the first quarter.
Given the substantial extra reward provided by U.S. government debt, money should have flowed stateside, bolstering the dollar versus the euro. Capital, after all, tends to follow higher yields. But that didn’t happen. Instead, the euro stayed comfortably above $1.20 for nearly the entire quarter, reaching a three-year high of $1.25 in January and February. Optimism reigned that the Eurozone’s economy would steam ahead after outperforming the U.S. in 2017 with its best rate of growth in a decade. The common currency also found support from the prospect that the European Central Bank (ECB) would begin to raise interest rates by the end of 2018.
So far in the second quarter, though, that currency dynamic has reversed course. The euro fell to a four-month low of $1.19 versus the greenback on May 4. From a “euro-negative” perspective, the decline has been driven by a series of disappointing Eurozone economic data releases. According to Eurostat, first-quarter GDP growth slipped to an 18-month low of 0.4%, rekindling anxiety over the durability of the region’s recovery. More worrisome for the ECB was a year-over-year drop in headline inflation to 1.2% in April. Stripping out food and energy costs, core inflation slumped to 0.7%—even further below the ECB’s 2% target. Lastly, talk of an ECB rate hike in 2018 has all but vanished.
Meanwhile, a number of factors have helped the dollar fight the euro back to a draw in 2018. The U.S. economy is poised to accelerate as fiscal stimulus kicks in and inflation begins to trend modestly higher. Moreover, the Fed is widely expected to continue its shift to tighter monetary policy. Rising U.S. Treasury yields are a product of this higher inflation and an emboldened Fed. After closing at or slightly above the 3% level for a few days in late April, the yield on the 10-year hovered between 2.94%-2.97% during the past week, closing at 2.95% on May 4.
Interestingly, the dollar’s rally may not have been significantly aided by the higher income advantage offered by Treasuries. Instead, this latest leg up for the U.S. currency may have been fueled by “short” dollar bets made by hedge funds who believed the greenback would continue to weaken. These investors have been forced to buy the dollar to cover their trades.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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