What a difference a week makes! This time, U.S. equities embrace inflation

Brian Nick

The past week’s market highlights:

Quotes of the week:

"Hey Groucho, where do you invest your money?" asked a trader.
"I keep my money in Treasury bonds," replied Groucho.
"They don't make you much money," said the trader.
"They do," Groucho said drolly, "if you have enough of them."
– Groucho Marx, on how he made money in the Treasury market
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 2018 Outlook:
  • U.S. economy: Conditions are still running closer to “just right” than “too hot.”
  • Global economy: Overseas economies are improving, but the time for surprises is over.
  • Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
  • Fixed income: Bond markets offer few places to run to, even fewer places to hide.
  • Equities: Stronger corporate earnings growth should drive stock prices higher.

U.S. economy: Goldilocks has not left the building…yet

The Consumer Price Index (CPI) is always on the market’s radar, but the release of January CPI data on February 14 took on added importance in light of the better-than-expected increase in average hourly earnings (AHE) reported on February 2. That upside surprise triggered fears of a more aggressive Federal Reserve, sparking a wave of equity-market volatility and pushing Treasury yields higher. Investors fretted that a spike in the CPI could provoke another selloff.

Indeed, CPI jumped an above-forecast 0.5% in January and 2.1% over the past 12 months. Excluding food and energy prices, “core” inflation rose 0.3% for the month and 1.8% compared to a year ago. In contrast to the AHE-driven meltdown, however, U.S. equities rallied on the day of the release, brushing off concerns over inflation and higher interest rates.

With the U.S. government already planning to increase deficit spending, January’s CPI release helps confirm our expectation for faster inflation in 2018. Nonetheless, higher inflation and its associated risks (e.g., tighter financial conditions and diminished consumer purchasing power) don’t yet pose serious risks to the U.S. economy. In fact, we believe a “Goldilocks” scenario of solid growth and modest price increases should persist for some time.

Small business owners seem to agree, with the NFIB Small Business Optimism Index in January coming within earshot of November’s multi-decade high. Although finding qualified workers to fill open positons remains a struggle for business owners, they believe now is a good time to expand. Homebuilders and consumers were similarly upbeat in February, as represented by the NASB Housing Market Index and the University of Michigan Consumer Sentiment Index.

Taken together, the CPI and AHE data have solidified the market’s expectations for two Fed rate hikes in the first half of the year: fed funds futures’ implied odds for a one-two punch in March and June reached 66% on February 16, with March’s move a near certainty (95%).
Against this backdrop, the yield on the bellwether 10-year Treasury touched a fresh four-year high of 2.91% on February 14 before falling to 2.87% to end the week. In our view, Treasury yields will continue to rise, and barring a major market shock resulting in increased demand for safe-haven assets, we would not be surprised if the yield on the 10-year note topped 3% in the near term. Higher yields reflect the strong global economy and the U.S. Treasury’s plan to issue significantly more debt this year. Moreover, the Fed has penciled in three rate hikes in 2018, while continuing to scale back its massive bond portfolio. Unwinding its balance sheet will also add supply to the market, potentially pushing up yields.
At the same time, Treasury demand could diminish, especially if historically active buyers (such as foreign central banks and governments) slow or reduce their purchases as concerns around dollar weakness grow.
In non-Treasury fixed-income markets, high-yield corporate bonds returned 0.50% for the week through February 15, thanks in part to a lift from rising oil prices. The gain in high yield trimmed its year-to-date loss to -0.79%. Results for most other segments of the bond market during the week were negative amid strong outflows. With liquidity tight in some areas of the market, funds have been forced to sell their most liquid securities to meet redemptions. It’s likely this dynamic will shift as conditions relax.

Equities: The U.S. stock market “grows up” and goes up

After a brief foray into correction territory on February 8, when the S&P 500 Index was down more than 10% from its late-January peak, the index began a six-day winning streak. During the past week, the S&P 500 surged 4.3%—its best one-week gain in five years—bringing it back into the black with a year-to-date return of around 2.5%. European shares followed U.S. markets higher, with the STOXX 600 rising 3.3%. For U.S. dollar-based investors, the greenback’s decline versus the euro amplified that gain to an even more robust 5.2%.
With this week’s rebound in the books, investors may be wondering why stocks rallied following the release of January’s hotter-than-anticipated CPI data after tumbling in the wake of rising AHE. We believe it’s because equities have “gotten over” the growing pains that sometimes occur in the early phases of a rising-rate environment. For example, in both 2004 and 2013, in response to rising interest rates, stocks briefly corrected, only to regain their footing shortly thereafter. This time appears to be no different. In fact, given our forecast for strong corporate profits in 2018, and with a record number of S&P 500 companies issuing positive guidance for 2018 (per FactSet), we expect stock prices to move higher from here despite the likelihood of higher volatility.
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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