Political wrangling in Washington proves taxing for global equities

Brian Nick

Article Highlights

Quote of the week

“What’s the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” ― Mark Twain

The Lead Story: Concerns over tax reform outweigh strong Q3 corporate earnings

After advancing for eight consecutive weeks, most recently on expectations for business-friendly tax relief, U.S. equities fell about 0.2% for the week. Driving this decline was news that Senate Republicans were considering a tax-reform bill that diverges from the House proposal. In particular, the Senate’s version delays corporate tax cuts until 2019 rather than implementing them next year. Amid this uncertainty, investors rotated out of cyclical shares such as financials and into stocks offering quality growth potential, especially those of technology companies.

However, markets continued to get a lift from solid (high single-digit) third-quarter corporate revenue/earnings growth. According to FactSet, with 81% of S&P 500 companies having reported through November 3, 74% have delivered positive earnings-per-share surprises, and 66% have registered better-than-expected sales results. In our view, investors will eventually turn their attention away from the short-term “noise” in Washington, refocusing instead on steadily improving corporate profits.
Outside the U.S., Europe’s STOXX 600 Index suffered its worst one-week fall (1.9% in local terms) in three months, as lackluster earnings deflated optimism over encouraging Eurozone economic data.
This sour mood did not extend to Japan, though. Before retreating on November 9 and 10, the Nikkei 225 Index hit a 25-year high, bolstered by an 18% surge (in yen terms) over the past two months.  A number of factors have fueled this advance. These include:
  • a slightly weaker yen, which benefits Japan’s export-heavy economy;
  • positive corporate earnings;
  • political certainty after Prime Minister Shinzo Abe’s resounding win in October’s parliamentary elections; and
  • heightened demand from foreign investors, who have been snapping up Japanese stocks at their fastest pace in four years.

These tailwinds notwithstanding, we expect the Nikkei’s rally to fade. Investor capital should ultimately find a home in select markets within Europe or the developing world, both of which offer more attractive equity valuations and better growth potential.

In other news: A tough week for fixed-income investors

Amid the threat of inflation and a near-certain Federal Reserve rate hike next month, yields on longer-dated U.S. government bonds rose as the week concluded. For example, after remaining rangebound for most of the week, the yield on the bellwether 10-year note jumped by seven basis points (0.07%) on November 10 alone to close at 2.40%. (Bond yield and price move in opposite directions.) Intensifying this dynamic is the recent start of the Fed’s gradual unwinding of its massive balance sheet.

Non-Treasury markets also struggled. For the week ending November 9, high-yield (HY) corporate bonds (-0.75% total return) were hit by outflows as some of the largest HY bond issuers produced lackluster quarterly results. Technical factors hurt investment-grade corporate bonds (-0.22% total return), which faltered as companies rushed to issue debt before any tax changes kick in.
A few sectors bucked this negative trend. Commercial mortgage-backed  and asset-backed securities, for example, posted small gains—illustrating the importance of building a diversified portfolio.
Despite the week’s downturn in certain asset classes and pickup in volatility, we doubt a significant market adjustment is imminent. Inflation risks are modest, and near- and intermediate-term recession risks still muted. Additionally, incoming Fed Chair Jerome Powell is likely to continue the Fed’s gradual, data-dependent shift to higher rates. More significant selloffs, should they occur, could provide buying opportunities.

Below the fold: No sign of letup in the Eurozone recovery

The Eurozone’s manufacturing and service sectors began the fourth quarter on a high note. Markit’s final Purchasing Managers’ Index for October registered 56, well above the 50 mark separating expansion from contraction and among the highest readings over the past 6½ years. Business optimism stayed elevated, as companies benefited from surging domestic demand and expectations for ongoing strong business and consumer spending. Also, the rate of job creation reached a multi-year high.

Not surprisingly, then, the European Commission raised its 2017 Eurozone real GDP growth rate from 1.7% to 2.2%—the region’s fastest pace in a decade.

Meanwhile, U.S. labor markets kept up their positive momentum on the heels of October’s healthy payrolls data. Job openings rose to 6.1 million in September, according to the Labor Department’s JOLTS report. Openings have been at or near record-high levels since June. And although first-time unemployment claims increased by a more-than-expected 10,000, to 239,000, the less volatile four-week moving average fell by 1,250, to 231,250, a 44-year low.

The Back Page: Emerging-markets debt remains attractive despite recent dollar strength

Following a period of weakening against foreign currencies through most of the year, the dollar has rebounded over the past few months, driven by the prospect of tax reform and expectations for a more hawkish Fed going into 2018. A strengthening dollar is often seen as unfavorable for emerging-markets debt (EMD). In the case of hard-currency (dollar-based) EMD assets, issuers must pay more local currency to satisfy their dollar-based obligations. At the same time, local-currency denominated investments feel the squeeze of declining foreign currency values.

These effects, however, are differentiated among specific markets and may be tempered for a variety of reasons:

  • Over the years, EM countries/issuers have developed a diversified debt structure in which a larger portion of their debt is denominated in local currency rather than in dollars.
  • The maturity profile of the debt has been lengthened significantly, so the impact of any short-term dollar strength is fairly muted in terms of the ability to repay.
  • Many EM countries and companies earn revenues in dollars due to their export profile.
Against this backdrop, we believe the U.S. dollar’s recent rally has not diminished EMD’s attractiveness as an asset class. EMD continues to be supported by a synchronized global economic expansion and modest inflationary pressures—especially wage growth—which have allowed central banks to gradually normalize policy. And for yield-starved investors, real EM rates look compelling relative to the negative real rates in many developed countries.

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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