U.S. equities yield to pressure from the bond market

Brian Nick

The past week’s market highlights:

Quote of the week:

“Once the number three, being the third number, be reached, then lobbest thou thy Holy Hand Grenade of Antioch towards thy foe, who, being naughty in my sight, shall snuff it.”– From “Monty Python and the Holy Grail”
As part of our new format, we are presenting 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.

Fixed income and equities: 3%? It’s just a number

As the week began, investors might have been feeling a sense of déjà vu. The bellwether 10-year Treasury yield, which had been rising steadily since April 2, stood at 2.96%, a mere four basis points (0.04%) below the psychologically important 3% mark. Just two months before, on February 21, the 10-year had reached 2.94% after starting the year at 2.40%. That ascent, however, stalled amid a number of factors, including trade-war fears and cooling inflation expectations.
But on April 24, the 10-year note closed at 3%, reaching the threshold at last. Even though this “milestone” garnered numerous—and frequently negative—headlines, there’s nothing inherently meaningful about a 3% yield. So why did the financial press pay such close attention? Because a) 3% is a round number, and b) the 10-year hasn’t reached this level in more than four years.
Although the 10-year yield retreated from its previous near-3% heights in February, we expect no such similar behavior this time. A year-end close of 3.25%-3.50% is possible, as the government issues more Treasuries to fund tax cuts and deficit spending, fiscal stimulus kicks in, and wages improve. In our view, modestly higher Treasury yields also represent expectations for healthy levels of inflation and stronger economic growth—expectations shared by the bond market and the Federal Reserve.

U.S. stocks, which have often rallied during periods of rising rates, struggled for direction. The S&P 500 Index was essentially flat for the week, even as robust, better-than-expected first-quarter earnings announcements rolled in. According to FactSet, with 53% of the S&P 500 companies reporting through April 27:
  • 82% have beaten earnings-per-share estimates
  • Earnings have topped estimates by 8.0%
  • Earnings growth, on average, has jumped 25% compared to the first quarter of 2017.
Much to investors’ disappointment, however, companies have been scarcely rewarded for their strong performance. Firms beating earnings expectations have seen their stock rise by just 0.1% during the two days before and two days after releasing earnings. Meanwhile, shares of companies reporting weaker-than-expected earnings have fallen by about 1% during the same time frame.
Technology and other high-growth companies, in particular, have been hit with underperformance “penalties” amid investors’ concerns that higher interest rates will squeeze future corporate profits. The possibility of a recession within a year or two added to the unease.
Across the Atlantic, European companies haven’t kept pace with their U.S. counterparts, posting first-quarter earnings only about 1.5% above estimates. Encouragingly, analysts have revised up their forecasts for earnings growth to the mid-to-high single digits.

Against this mildly supportive backdrop, the STOXX 600 Index (+0.73% in local terms) notched its fifth consecutive weekly advance. The euro’s decline to a three-month low of $1.21 lifted shares of Eurozone exporters, which make up more than 40% of the region’s economy. Fueling the euro’s drop were cautious comments on the region’s recovery by European Central Bank (ECB) President Mario Draghi following the ECB’s April 26 meeting. As expected, the ECB made no changes to its policy statement, left interest rates unchanged, and repeated its promise to keep buying bonds until the end of September, or beyond, if necessary.

U.S. economy: Private investment drives first-quarter growth

According to the government’s advance estimate, first-quarter GDP grew at an annual rate of 2.3%, slightly ahead of expectations (2.0%) but slower than the 2.9% pace of the fourth quarter. For the first time in recent memory, personal consumption expenditures, which grew by just 1.1%, were not the biggest contributor to growth. Instead, private fixed investment was the dominant driver of growth in the first quarter.
Also surprising was the 6.1% surge in nonresidential fixed investment, which was largely due to a 12.3% increase in spending on structures (relating to mining and energy). Net exports and inventory accumulation contributed a total of 0.6% to growth. These components are typically more volatile, however, and their figures are often revised in future estimates. Final sales to private domestic purchasers, a measure some economists prefer as a gauge of domestic economic health (because it strips out inventories, trade, and government spending)—grew 1.6%. Surprisingly, residential investment remained flat.
Although consumers spent little more in the first quarter than they did in the fourth, they clearly benefited from an improving economy and lower individual tax rates. Disposable incomes grew by 6.2%, versus 3.8% in the fourth quarter. Meanwhile, personal savings rose by 0.5%, to 3.1%.
Markets pay nearly as much attention these days to the Employment Cost Index (ECI), a key measure of productivity, wage growth, and employer-paid benefits, as they do to GDP. The ECI rose 0.8% in the quarter—tied for the fastest rate of this expansion—translating to a healthy year-over-year climb of 2.6%. Meanwhile, private wages rose by 2.9%, more rapidly than at any point since 2008.
Meager consumption growth notwithstanding, the first quarter certainly ended with greater economic momentum than it began. We had expected a faster start to 2018, but consumers seemed to fall into a lull in January and February. By March, they were coming out of hibernation, a sign that government stimulus measures were beginning to take effect. Growth may top out at rates as high as 3.5% in the next few quarters, as fiscal stimulus ramps up and consumer spending recovers further. In light of this, we are maintaining our current GDP growth forecast of 2.8% for 2018 as a whole.
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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