That’s more like it! U.S. equities post best week in two months

Brian Nick

The past week’s market highlights:

Quote of the week:

“The hand which strikes also blocks.” – Chinese proverb
Each week, we will present 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.

Asset allocation: We’ll have what Harry’s having

Harry Markowitz, Nobel laureate and father of modern portfolio theory, once called diversification “the only free lunch in finance.” That’s because building a portfolio consisting of assets with low or negative correlations to each other—meaning they tend not to perform in lockstep or they move in opposite directions, respectively—can help reduce overall investment risk without sacrificing returns.
To be sure, even diversified investors endured a rough start to 2018. Both the S&P 500 Index and Bloomberg Barclays U.S. Aggregate Bond Index, a broad gauge of the investment-grade (IG) fixed-income market, posted negative returns from January through April, the first time that’s happened since 1994. The financial press has noticed. We’ve read a number of articles suggesting that asset allocation might have lost some effectiveness amid a supposed uptick in the correlation between stock and bond prices.
Based on rolling three-year periods from January 2000-May 2018, the S&P 500 and IG bonds have been reliably uncorrelated. For the most part, stocks have risen when IG bonds have slumped, while fixed-income has outperformed in periods of equity market turmoil. This latter dynamic was especially notable from 2000-2002, as the end of the tech bubble triggered an equity bear market. Providing ballast, IG bonds delivered an impressive total return of 33% over that three-year span.
Of course, these two portfolio building blocks frequently move in tandem over short time frames. During the Federal Reserve’s quantitative easing program, for example, there were a number of periods in which IG bonds rallied, as the Fed’s asset purchases pushed down yields. (Bond yield and price move in opposite directions.) Stocks also benefited during these periods, thanks to investors’ heightened appetite for risk.
In contrast, bond and equity investors alike felt the pain of the May 2013 “Taper Tantrum” triggered by then-Fed Chair Ben Bernanke’s suggestion that the Fed would gradually reduce, or taper, its monetary expansion. Prices of both U.S. stocks and U.S. bonds fell in unison in subsequent weeks. This past February, correlations rose sharply, albeit briefly, amid fears of yet another market tantrum. Fueled by expectations for higher inflation and a more aggressive Fed, the 10-year Treasury yield jumped 18 basis points, to 2.84%, during the week of January 29. Meanwhile, the S&P 500 began its quickest-ever 10% correction from an all-time high, eventually bottoming on February 8, as rates continued their rise.
Overall, though, correlations have not risen noticeably this year. Indeed, directionless markets and strong correlations rarely accompany one another. Since late February, the yield on the bellwether 10-year note has edged up only slightly, closing the week at 2.97%. U.S. stocks have also changed little over that stretch.

For the remainder of this expansion, we expect stocks to grind higher, helped by continued solid earnings growth and a stronger global economy. At the same time, rising interest rates, driven by ongoing Fed tightening, are likely headwinds  for IG bonds. However, it may be bonds’  turn to outperform once a recession hits. Regardless of the economic environment, though, we believe investors are best served by developing a long-term asset allocation strategy that matches their age, goals, and risk tolerance, and by rebalancing when necessary to maintain the original allocation.

U.S. equities: It hasn’t paid to be defensive

The S&P 500 has delivered a modest return of around 2.7% in 2018. Looking under the hood, however, reveals a wide performance disparity among its underlying 11 sectors, with most of the divergence coming over the past six weeks.
Only three sectors have outpaced the broader index for the year-to-date period ended May 10: Information Technology (11.6%), Energy (7%), and Consumer Discretionary (6.5%). On average, first-quarter earnings for these cyclical (or economically sensitive) stocks topped expectations by the most of any sector. In addition, Energy and Tech companies posted the quarter’s highest average earnings growth, with Energy generating a whopping 100% year-over-year increase.
On the down side, Consumer Staples (-12.7%), Telecommunications Services (-11.2%), and Utilities (-3.7%) have lagged the most. Given these defensive sectors’ long-standing ability to weather market volatility, such poor results may be somewhat surprising considering this year’s wide swings in stock prices—a common occurrence during an economic cycle’s later stages. However, their relatively high dividends look less enticing compared to the rising “risk-free” yields offered by U.S. Treasuries, contributing to the underperformance.
But that’s not the only problem plaguing defensive shares. Coming into 2018, investors’ prolonged search for income had driven up their valuations well beyond the levels expected nine years into an economic expansion. In fact, these sectors are generally “pricier” than their cyclical counterparts.
So how might diversified equity investors position their portfolios? Because we believe the U.S. economic cycle still has  legs, sticking with the more attractively valued cyclicals could offer the greatest near-term growth opportunities. In the meantime, waiting for valuations to decline on defensive stocks may be prudent.
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.
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.
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Any investment in taxable fixed-income securities is subject to certain risks, including credit risk, interest-rate risk, foreign risk, and currency risk. There are specific risks associated with international investing, which include but are not limited to foreign company risk, adverse political risk, market risk, currency risk and correlation risk. In addition, investing in securities of developing countries involve greater risk than, or in addition to, investing in developed foreign countries.
The investment advisory services, strategies and expertise of TIAA Investments, a division of Nuveen, are provided by Teachers Advisors, LLC and TIAA-CREF Investment Management, LLC.