U.S. equities catch their breath

Brian Nick

Article Highlights

Quote of the week

“No, I'll stand my ground/Won't be turned around/And I'll keep this world from draggin' me down/Gonna stand my ground.” - Tom Petty, from “Won’t Back Down”

The Lead Story: Look at the trend, not September’s headline jobs number

We knew the effects of hurricanes Harvey and Irma would make it difficult to interpret September’s payroll numbers, released on October 6. Although the U.S. economy shed 33,000 jobs last month, the decline reflected a steep drop in the number of leisure/hospitality positions, most likely in Texas and Florida. That’s why we wouldn’t read too much into the headline figure. Despite September’s stumble, the unemployment rate fell to a fresh 16-year low of 4.2%. According to the Bureau of Labor Statistics, neither this nor the increase in the labor-force participation rate, to 63.1%, was distorted by the storms. Encouragingly, wages grew 0.5% in September, improving their year-over-year gain to 2.9%.

All told, this employment data—controlling for weather—indicates a slow trend toward a tighter labor market in which wages continue to rise and fewer jobs are created because skilled, available workers have become scarce. Against this backdrop, we believe the Fed is even more likely to hike in December and to fulfill its current expectation to raise rates three times next year.

Fixed-income markets treated the dip in payrolls as temporary, focusing instead on robust economic data releases and the pickup in wages. The yield on the bellwether 10-year Treasury note closed at 2.37% on October 6, up from 2.33% to begin the week.

In a continuation from the prior week, returns for non-Treasury fixed-income sectors were mixed. Positive fund flows helped investment-grade (IG) and high-yield corporate bonds post modest gains. Looking ahead, we expect both asset classes to benefit—IG bonds in particular—amid an environment of relatively good corporate profits, coordinated global growth, and the possibility of U.S. fiscal stimulus.

In other news: Taking stock of the U.S. equity market

Over time, two factors have driven up the stock market: (1) investors’ higher earnings expectations and (2) their willingness to “pay up” for those profits. Between November 9, 2016, and March 1, 2017, the second factor was almost solely responsible for the 11% jump in the S&P 500 Index (from 2,163 to 2,395). As a result, the forward price-to-earnings (P/E) multiple for the index rose, from 16.2x to 18.0x, a more than 15-year high.

Since this past spring, however, the S&P 500 has slowly yet steadily advanced on the back of rising corporate profits and the prospects for their continued growth. This shift appears to have imbued investors with confidence in both the durability of the U.S. economic expansion and the path of future earnings gains. Indeed, over the past seven months, next-12-month consensus earnings forecasts have risen by 10%. P/E ratios, meanwhile, have edged down, to 17.7x, but remain elevated compared to their historical average.

What does this imply for the S&P 500’s performance for the remainder of the year? We previously pegged a year-end target of 2,400. Where did we “go wrong”? For starters, we thought the political gridlock in Washington would have dissuaded investors from paying such a high premium for stocks. Instead, the market has focused like a laser on the improvement in corporate profits at the expense of flashier political news. Consequently, investors have treated dips triggered by negative headlines as buying opportunities.

While 2,400 may seem like a steep fall from the S&P’s current level given the spate of record-high closes, remember that our target is just a 6% (or so) decline away.  Disappointing earnings growth in the coming reporting season, in our view, remains the most likely cause of a pullback of that magnitude.

In the past week, however, U.S. equities were in no mood for a correction. Supported by strong economic data and optimism over the near-term passage of a tax reform bill, the S&P 500 Index extended its string of consecutive record-high closes to six by rising on the first four days of the week. However, a “Friday fade” trimmed its advance for the week to 1.2%. In 2017 so far, the S&P 500 has returned more than 15%. Remarkably, though, the index has gained 1% or more on only four trading days.

In Europe, the STOXX 600 Index lost 0.31% in U.S. dollar terms. German stocks got a lift from a slide in the euro, which boosted exports from the continent’s biggest economy. At the same time, stocks in Spain see-sawed amid threats by Catalonian separatists to declare the region’s independence.

Below the fold: How did the U.S. economy fare in Q3?

Although we’ll have to wait until October 27 for the government’s initial GDP estimate, reports suggest that hurricanes Harvey and Irma have had limited impact on U.S. third-quarter growth. There was plenty of positive news among the week’s data releases:
  • Manufacturing activity climbed to 60.8 in September, its highest reading since May 2004, according to the Purchasing Managers’ Index (PMI) published by the Institute for Supply Management (ISM). (Readings above 50 indicate expansion.)
  • The ISM’s service-sector gauge also surged in September, to 59.8, a 12-year high. This report is especially important because professional services, health care, and other non-manufacturing industries make up roughly 80% of U.S. GDP.
  • After spiking to 298,000 in early September, initial jobless claims fell to 260,000, continuing their fall toward pre-hurricane levels. The less-volatile four-week average slipped as well, by 9,500, to 268,250.
  • Factory orders rebounded 1.2% in August after July’s sharp decline.
  • The trade deficit dropped 2.7% in August, to $42.4 billion, from $43.6 billion in July. A strengthening global economy and a weaker U.S. dollar bolstered exports. Imports were essentially unchanged.

The Back Page: A good story made great

ISM’s manufacturing PMI seems to signal that U.S. manufacturers were firing on all cylinders in September. But just as we looked beneath September’s headline payroll number, we think a similar review would be prudent here. 

The ISM figure was severely distorted by temporary conditions caused by the recent hurricanes, particularly slower supplier delivery times. Historically, slower deliveries have indicated that manufacturers’ supply chains have been unable to keep up with demand. This typically occurs when business is good. Counterintuitively, then, sluggish delivery times contribute positively to the index.

Last month, the ISM supplier delivery sub-index rose to its highest level since July 2004. But most of that spike was caused by the hurricanes’ disruptions, not by burgeoning demand.  Overall, September’s strong showing lifted the 2017 PMI average to 57.1, which corresponds to annualized GDP growth of 4.4%, according to the ISM.

Although we’re encouraged to see manufacturing on the rise, October’s PMI is likely to decrease as the pace of deliveries improves. GDP growth of 4+% is not in the cards; 2.2% or so is more like it, in our view, in keeping with this economic recovery’s moderate trajectory.
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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