U.S. equities end November with a flourish but begin December in the red

Brian Nick

Article Highlights

Quote of the week

“No tears in the writer, no tears in the reader. No surprise in the writer, no surprise in the reader.” – Robert Frost

The Lead Story: Events in Washington move U.S. equities

The predominantly large-cap S&P 500 Index rose 1.8% over the first four days of the week, fueled by optimism over the passage of tax reform. However, stocks retreated 0.2% on Friday, December 1, amid reports that former National Security Adviser Mike Flynn had pleaded guilty to lying to the FBI and was prepared to cooperate in the ongoing investigation into Russia’s alleged interference in the 2016 presidential election. For November as a whole, the S&P 500 gained 3.1%, its eighth consecutive monthly advance. Year to date through December 1, the index has returned over 20%.

The small-cap Russell 2000 Index also rallied during the week despite the “Friday fade.” Although its 15.1% year-to-date gain (through November 30) lags that of the broader market, the Russell 2000 has outperformed over the past three months, 10.2% versus 7.7%. Because small caps tend to pay a higher average tax rate than do large caps, they are more  responsive to changes in tax policy, making them a primary beneficiary as Congress has stepped up the pace of tax reform legislation.

Looking under the S&P 500’s hood, Technology stocks were uncharacteristically volatile during the week, suffering a 2.6% drop on November 29—their worst day in five months—before recovering the next day. This year, tech shares have been boosted by strong reported earnings and upward revisions to future earnings but have wobbled when the outlook for tax reform has improved, as was the case during the week. One major reason for their underperformance under this tax-overhaul scenario: tech companies pay an average tax rate of 18.5%, according to Bloomberg. As a result, the Senate’s proposal to cut the top corporate rate from 35% to 20% wouldn’t help these firms as much as those in the Financials sector, for example, which tend to be more heavily taxed.

Tech has thrived when the market has focused on growth prospects, as it has done through much of 2017. When investors have homed in on cyclical tailwinds and reflation, though, Financials and Energy have been their preferred trades. All things considered, we think tech stocks may have more room to run. Thanks to robust earnings, the sector looks no more expensive today relative to the broad market than it did to start the year, despite outpacing the next-best performing sector, Health Care, 38.8% to 22.9% for the year to date through November 30. In our view, this makes comparisons to the 1997-2000 tech bubble misguided.

Solid economic data failed to lift the mood in overseas equity markets, as Europe’s STOXX 600 Index lost 0.7% in dollar terms. For the year to date, the euro’s 13.4% rise versus the dollar amplified a gain of 6.2% in local terms to 19.9% for dollar-based investors.

In fixed-income markets, the yield on the 10-year Treasury whipsawed as a result of the events in Washington. After closing at a one-month high of 2.42% on November 30 amid tax-reform optimism, the yield fell to 2.36% the next day—about where it began the week—as investors’ risk appetite diminished.

Meanwhile, the yield on the two-year security also closed the week essentially unchanged, at 1.78%. Investors have been watching the short end of the yield curve rise for nearly three months, driven by a greater chance of Fed hikes in 2018. At the same time, the long end has been trading within a narrow range, restrained by low global rates and soft inflation.

In other news: Our take on the tax bill

On December 1, Senate Republicans announced that they had the 50 votes needed to pass their version of tax reform. If they are indeed able to secure the necessary votes, lawmakers will then need to reconcile the differences between the House and Senate bills in a conference committee before the full Congress votes on a joint bill. With voting expected to run along party lines, Republicans have little wiggle room: they can lose only two votes in the Senate and about 20 in the House.

Because the finish line is in sight, we doubt Congress will allow this effort to fail. Republicans view this opportunity to overhaul the tax code and deliver tax cuts as vital to their chances of retaining control of Congress in next year’s midterm elections. We believe there’s a 75% chance a bill will pass by the end of March 2018.

In our view, a revised tax code will not significantly boost the U.S. economy in the near term, although companies currently paying an average tax rate of more than 20% will certainly benefit. This year’s nearly uninterrupted U.S. equity rally, boosted by an unrelenting rise in corporate earnings forecasts, seems to indicate that the market expects the beneficiaries of lower taxes to be shareholders, not workers. That’s why we believe it’s difficult to forecast any change in wages, inflation, or consumer behavior regardless of whatever legislative details emerge.

Below the fold: The price is right for consumers

With more money in their pockets, inflation under control, and the jobless rate currently at a 17-year low, consumers haven’t felt this good in, coincidentally, 17 years. Among the week’s reports:

  • Bolstered by October’s healthy 0.4% jump in personal income, consumer spending rose 0.3%, following September’s 0.9% gain.
  • Consumer confidence grew in October for a fifth consecutive month, to a fresh 17-year high, according to the Conference Board’s index. Consumers’ optimism was driven by expectations for further improvements in the labor market and the broader economy.
  • Inflation, as measured by the Fed’s preferred inflation barometer (the PCE index), increased 0.1% in October and 1.6% over the past 12 months. The “core” PCE index, which excludes food and energy costs, rose 0.2% and 1.4% compared to a year ago. Even though both measures were well below the Fed’s 2% target, we still believe the Fed will raise rates in December.
Housing releases were also upbeat:
  • New-home sales surged 6.2% in October, to their fastest pace in a decade, and 18.7% over the prior 12 months.
  • Home prices increased, with the S&P/Case Shiller 20-City Composite Index rising 0.4% in September and 6.2% versus a year ago.
Across the Atlantic, the Eurozone’s manufacturing and service sectors continued to gather steam. Markit’s “flash” (preliminary) Purchasing Managers’ Index for November registered 57.5, up from 56 in October and its best showing since April 2011. Firms are struggling to meet demand even as they create jobs at the fastest rate since the dot-com boom. Markit believes that last month’s PMI equates to a 0.8% expansion in fourth-quarter Eurozone GDP, which would cap the region’s best year in a decade.

Meanwhile, the European Commission’s economic sentiment gauge reached a 17-year peak in November. The buoyant mood was compounded by expectations of higher prices among manufacturers and consumers, a positive signal for the European Central Bank’s efforts to raise inflation closer to its 2% target.

The Back Page: Is that the sound of a housing bubble inflating? We don’t think so.

As housing prices continue to climb, some pundits are questioning whether another bubble is forming in the U.S. housing market. “Non pundits” may be thinking along the same lines: over the past 12 months, Google trends show an 1100% surge in online searches for the phrase “housing bubble 2017.”

Strong sales figures have lifted home prices a cumulative 52% since the bottom in March 2012, according to the Case-Shiller 20-City index. Moreover, “flips”—single-family homes bought and sold within a 12-month period—have reached their highest levels since 2006.

So could Americans be repeating the mistakes that led to a housing crash less than a decade ago? We don’t think so. In our view, rising prices demonstrate growing demand for housing. Buyers are so eager to close that builders hadn’t broken ground on more than one-third of all homes purchased in October. Moreover, housing starts and building permits jumped in October despite homebuilders’ difficulty finding qualified construction workers. This shortage should help support further increases in housing prices, as builders seek to maintain profit margins amid rising wages.

Residential investment has been a drag on U.S. GDP for most of this year. But with expected growth in construction, thanks in part to more job-training programs, we expect it to be a “plus” this quarter and in 2018.
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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