Despite the Fed’s bullish outlook, U.S. equities say, “Wait a minute”

Brian Nick

The past week’s market highlights:

Quote of the week:

“Skiing combines outdoor fun with knocking down trees with your face.” – Dave Barry
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.

Policy watch: Fed minutes show optimism on growth, little pressing concern on inflation

Minutes from the Federal Reserve’s January 30-31 meeting, released on February 21, convey confidence that the U.S. economy is poised to gain momentum. A number of Fed officials raised their GDP forecasts, encouraged by firm global growth, the potential for U.S. tax cuts to deliver a bigger-than-expected boost to the U.S. economy, and bullish equity markets.

A majority expressed the view that inflation, as measured by the PCE index, will approach the Fed’s 2% target over the medium term. A few, however, noted “an appreciable risk” of inflation continuing to fall short of that level.

Market reaction to the minutes’ release was swift. The yield on the 10-year Treasury note jumped to 2.95% before closing at 2.92% on February 21, a fresh four-year high. The S&P 500 Index, meanwhile, relinquished a gain of 1.2% to finish down 0.6% for the day. For the week as a whole, the index posted a modest gain, aided by a strong Friday rally.

Why the bearish response to such an encouraging assessment? Investors concluded—rightly, in our view—that the Fed intends to maintain a steady course of 25-basis-point (0.25%) interest-rate hikes. As of February 23, the market has priced in a 67% chance of three rate increases this year.

Still, fears of an overly aggressive Fed, in terms of both the pace and scope of interest-rate hikes, are likely misplaced. Although committed to further tightening, the Fed plans to normalize policy gradually, as conditions warrant.
A potentially greater source of market volatility is the sharp climb in Treasury yields this year. Yields have risen amid upside inflation surprises and increased Treasury issuance needed to fund tax cuts and U.S. government deficit spending. We watched the past week’s series of Treasury auctions closely to see if there would be enough demand to absorb the $258 billion of new supply being added to the market. Fortunately, there was—and yields were not forced dramatically higher in the process. In fact, the 10-year yield fell below 2.90% on February 23.
But one successful week of auctions likely won’t offer long-lasting relief from volatility. We think bond markets will be more reactive to a combination of economic data, Treasury demand, and equity price movements than they have been over the past several years, when quantitative easing provided a calm, steady backdrop. Now that global central banks are looking to withdraw stimulus, they may be less effective as a circuit breaker for financial stress—and less able to soothe market volatility. Such volatility makes for dramatic headlines, but in our view also presents opportunities for active fixed-income managers.

Global economy: Fewer surprises, mixed performance

In our 2018 Outlook, we focused on a number of investment destinations worthy of attention this year. Equity market performance in these countries and regions has been mixed thus far. Some markets have trailed the S&P 500 year to date, while others, including select emerging markets (EM), have outperformed.
One notable laggard has been the Eurozone. Even as its economy continues to grow at an impressive clip, expectations have largely caught up with reality, providing equity markets there with less buoyancy. A stronger euro may be weighing on the corporate earnings outlook, although we expect the dollar to stage at least a temporary comeback, which would help.
Meanwhile, February readings were softer for two closely watched Eurozone surveys: Markit’s Composite PMI (a gauge of the region’s service-sector and manufacturing activity) and the ifo Index (which measures business sentiment in Germany). Both indicators, however, remain consistent with strong economic performance. Indeed, based on hard data, the Eurozone is expanding at close to a 3% annualized clip in the first quarter. It remains the most compelling developed-market region for equity investors in 2018.
In the EM space, Brazil and Russia—two equity markets that we highlighted as showing the most potential heading into the year—have more than lived up to expectations. According to MSCI indexes, each has surged around 15% (in U.S. dollar terms) year to date through February 22, well ahead of the 3.4% return of the broader EM universe. Both countries feature early-cycle dynamics and have benefited from the significant rise in oil prices since the middle of 2017. Moreover, their central banks have further room to cut interest rates to stimulate their economies.
But challenges await. Brazil must achieve meaningful economic reform. For its part, Russia depends on the energy trade and remains a source of geopolitical risk in global markets. In both cases, however, longer runways for economic and earnings growth, coupled with reasonable equity valuations and inexpensive currencies, offer the potential for continued outperformance.
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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