08.11.17

Fears over North Korea rattle equity markets

Brian Nick

Article Highlights

Quote of the week

“An idle mind is the devil’s workshop.” – Proverb

The Lead Story: The market needs something to worry about.
 

With Congress home for summer, second-quarter corporate earnings season over, the Federal Reserve not scheduled to meet until September 19-20, and a potential debt-ceiling debate not likely until the fall, markets may have few major news stories to monitor in the near term. But monitor something they will, as information vacuums tend to get filled.|

During the week, fears of a military confrontation between the U.S. and North Korea dominated headlines. The S&P 500 Index, which had notched 15 consecutive sessions without closing up or down by 0.3% or more, fell 1.4% on August 10—its worst one-day showing in three months— before rebounding modestly the next day. For the week, the S&P 500 returned -1.4% yet outperformed Europe’s STOXX 600 Index (-2.2% in U.S. dollar terms).

Geopolitics has been a source of some painful summer downturns. For example, the S&P 500 plunged nearly 13% in August-September 2011 as the Greek debt crisis heated up. In August 2015, the index fell 12% amid worries over China’s sudden currency devaluation. Both of these corrections, while more severe than anything we expect to see this summer, were short-lived.   
 
Still, anxiety over North Korea (or developments in the investigation of Russia’s interference in the U.S. election, for that matter) could provide an “excuse” for stocks—and other risk assets—to retreat in the lightly staffed weeks before Labor Day. (Low trading volume exacerbates market movements.) It’s been over a year since the S&P has had a correction of more than 5%, and some investors may feel that we’re overdue for a pullback.

Even before this week’s headlines, the stock market seemed to be a bit on edge. In the second quarter, companies reporting better-than-expected earnings and revenues (so-called “double beats”) failed to outperform their sector peers in the three days following earnings announcements, as they normally have during earnings seasons dating back to 2003.  Concurrently, companies that disappointed on both fronts lagged by 3.8% versus “only” 2.7% historically.  These are signs that good news had already been priced in, while bad news was unanticipated and unwelcome.
 
Fixed-income markets traded in an orderly fashion despite the unsettling headlines. U.S. Treasuries and other safe-haven assets benefited from the “risk-off” tone. The yield on the bellwether 10-year note closed at 2.19% on August 11 after opening the week at 2.27%. (Yield and price move in opposite directions.) Results for non-Treasury sectors were mixed. High-yield bonds, which often take their cue from equities, returned -0.7% for the week through August 10. Structured products (asset-backed, mortgage-backed, and commercial mortgage-backed securities) all posted modest gains.

In other news: We defend value investing
 

The Wall Street Journal’s August 7 article “Value Loses Shine in Torrid Growth Era” caught our eye. The piece suggests that because growth stocks have thumped value shares this year, the discipline of value investing may be “losing its effectiveness” or have become passé. 

It’s true that value has lagged badly in 2017. Through August 10, the large-cap Russell 1000 Growth Index, led by a handful of Technology shares, has returned 15.7%, versus 4.5% for its value counterpart. But that doesn’t mean value has “lost its shine.” Just last year, value (+17.3%) soundly prevailed over growth (+7.1%).

And since the equity market bottomed in March 2009, value (+18.6%) has nearly kept pace with growth’s impressive 19.7% average annual return despite the fact that Financials and Energy, two key Russell 1000 Value Index sectors, have battled persistently low interest rates and volatile oil prices, respectively. From 2000-2008, value trounced growth by 8.5 percentage points per year—evidence that markets move in cycles. 

In short, we believe value stocks are important components of a broadly diversified portfolio and may be poised for a comeback. Financials have posted impressive earnings numbers in recent quarters, and Energy profits more than tripled in the second quarter. A steadier economic environment, both in the U.S. and abroad, should diminish growth’s relative attractiveness, particularly given its outsized performance in 2017.

Below the fold: Good men—and women—are still hard to find
 

Job openings jumped to a record 6.2 million in July, according to the Labor Department’s JOLTS report. At  the same time, hiring decreased, offering further evidence of the challenges companies face finding qualified employees. Nonetheless, the NFIB’s small-business sentiment index rose in July to within earshot of January’s 12-year high. (See “The Back Page” for more on small-business owners.)  

Also in July, headline and “core” inflation (which excludes food and energy prices) increased by only 0.1% and 1.7% year over year. In our view, monthly inflation readings will need to approach 0.2%, and trailing 12-month inflation 2%, for the Federal Reserve to raise rates in December. We still expect the Fed to unveil plans to shrink its balance sheet next month, regardless of the data between now and then.
 

Back page: Time to temper small-business optimism?

According to the NFIB survey, business owners expect the economy to improve and sales to pick up. Not surprisingly, they plan to add workers, too, even as finding qualified candidates, particularly in construction and manufacturing, remains challenging. In fact, nearly 20% of firms surveyed cite the skilled labor shortage as their top concern. 

It also appears that businesses are not “putting their money where their mouth is.” Owners’ expectations for boosting capital expenditures have been rising since 2013. However, actual capex spending has been muted during that time and may not increase anytime soon: nearly two-thirds of businesses surveyed expressed no interest in borrowing. One would expect stronger demand for credit as companies plan for expansion.

This seems to be yet another example of a divergence between positive “soft” data—reports based on sentiment surveys—and less encouraging “hard” data, which is derived from measurements of actual economic activity. Because the former will eventually be swayed by the latter, the latest instance of business optimism could be quite fragile. In our opinion, what’s currently registering as small business confidence may actually be a wait-and-see approach.
 
At the same time, the social welfare net has expanded in the form of rising levels of unemployment insurance, disability claims, and Medicaid enrollments. This could also explain some of the sustained drop in labor force participation. One point is clear: losing such a large chunk of men during their prime earning years hinders the nation’s productivity and reduces its long-term potential growth rate. The longer they remain unemployed and their skill sets diminish, the greater the negative economic impact.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of TIAA Global Asset Management, its affiliates, or other TIAA Global Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.

Nuveen, LLC, formerly known as TIAA Global Asset Management, delivers the expertise of TIAA Investments and its independent investment affiliates.

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