The last week’s market highlights:
Quote of the week:
“I was married by a judge. I should have asked for a jury.” – Groucho Marx
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Midyear Outlook:
- U.S. economy: Running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Central banks aren’t all on the same wavelength.
- Fixed income: Starting to prefer higher-quality assets.
- Equities: Earnings are supporting prices, but expect plenty more volatility.
- Asset allocation: Remain risk on, but focus on quality.
U.S. economy: A better-than-expected jobs report helps cool inflation risks
The risk of higher inflation seems to have overtaken the risk of slower growth. Major inflation readings (including the consumer price index and the PCE index, the Fed’s preferred inflation gauge) have reached or exceeded the Fed’s 2% threshold over the past year. In addition, the price of crude oil, which hovered near 3½-year highs last week, has been climbing despite increased supply from OPEC and steady U.S. inventories.
Rather than contribute to economic overheating, June’s strong payroll numbers acted as a coolant. The headline addition of 213,000 jobs exceeded expectations for 195,000. But an uptick in the unemployment rate (to 4.0% from May's 18-year low of 3.8%) and the labor force participation rate (to 62.9% from 62.7%) as more people joined the workforce helped dampen wage growth. Average hourly earnings rose just 0.2% in June, down from 0.3% in May, and 2.7% compared to a year ago, below expectations for 2.8%.
The fact that the labor force participation rate has remained around 63% since mid-2013 is one of the Federal Reserve’s—and Janet Yellen’s—unheralded achievements, in our view. The Fed has allowed the economy to run hot enough for the percentage of people looking for and finding employment to increase, even as the number of working-age people has shrunk as a percentage of the total population.
Payroll data aside, evidence suggests that a pickup in producer and consumer price inflation might be on the way. Businesses may put spending plans on hold amid the trade-war uncertainty. This could limit gains in worker productivity, potentially leading to higher prices. Indeed, minutes from the Fed’s June meeting revealed that companies had begun to express concern that U.S. trade policy could hurt their bottom line.
If it were to occur, a widespread, tariff-driven pullback in private investment could trigger what we believe would be the worst possible ending for this economic cycle. Businesses would get hit both by reduced growth from investment and lower worker productivity. Concurrently, we’d expect the Fed to continue raising interest rates even as the cumulative effect of fiscal policy remains uncertain. The end result might be an inverted yield curve, which often precedes a recession.
In fact, yield-curve watchers were out in force last week, with some raising concerns that the flattening yield curve could herald an economic slowdown. The gap between 2- and 10-year Treasuries narrowed to just 29 basis points (0.29%)—a fresh 11-year low—on July 5. The yields closed the week at 2.53% and 2.82%, respectively. Despite this flattening, we expect the U.S. economy to continue to expand through at least the end of 2019. Last week we received further evidence of the economy’s resilience. According to the Institute for Supply Management, manufacturing and service-sector activity rose for the second consecutive month in June.
Global economy: Are emerging markets oversold?
Emerging-market (EM) assets have come under pressure in recent months, with a stronger U.S. dollar, trade protectionism, and flare-ups in individual countries all contributing to investor concern. In theory, the global economic and market environment in 2018 has all the makings of a banner year for EM: U.S. economic growth (and along with it, the U.S. dollar) appears to be peaking; the global economy is accelerating, pushing up commodity prices; and EM policymakers have ammunition in the form of monetary policy and ample foreign reserves to stave off exogenous threats.
Consider China, where the central government remains focused on protecting domestic economic growth and has numerous levers to pull. China’s President Xi Jinping retaliated immediately against the Trump administration’s 25% tariff on $34 billion in Chinese goods, which took effect July 6. (U.S. tariffs on a wider array of Chinese imports could soon follow.) While China’s central bank has not “weaponized” its currency with an orchestrated devaluation, the yuan’s 3.5% decline over the past three weeks is the most dramatic drop since 1994 and bears watching.
The global trade din that’s been building up since March has spooked investors. According to the Institute for International Finance, portfolio flows from EM exceeded a combined $20 billion in May and June—the first time in a decade that both debt and equity flows were negative for two months in a row.
Flows notwithstanding, however, the economic impact of tariffs has yet to show up in EM data releases. Even the most recent Purchasing Managers’ Indexes (PMIs), which are highly sensitive to how changes in sentiment affect demand or supply chains, haven’t yet reflected tariff-driven slowdowns. Meanwhile, the structural drivers that made EM so attractive a year ago are still in place: EM has produced faster economic growth than developed markets, and many EM countries have solid current account balances, strong balance sheets, and deep credit markets.
While EM economies appear resilient for now, EM asset classes are hurting. Currencies, for example, lost 8.6% of their value against the U.S. dollar in the second quarter, according to the JP Morgan EM Currency Index. And spreads on dollar-denominated EM sovereign credit have widened by two to three times those of U.S. corporate credit (including high yield). Yields on local-currency debt are higher, too, despite most EM central banks remaining in easing or pausing mode, and global inflation is not yet an acute threat.
Equity markets have also had a rough ride. The MSCI EM Index fell by 8.0% in U.S. dollar terms in the second quarter, versus a 1.9% rise for the developed-market MSCI World Index. The decline in EM stocks leaves them significantly undervalued. On a price-to-book basis, EM equities are trading at a 23.6% discount to the MSCI World’s long-term average, while price-to-earnings ratios (EM is currently trading at a 26.5% discount to the MSCI World) imply the asset class is relatively cheaper today than at any point throughout the financial crisis of 2008-2009.
In short, EM assets have been hit hardest by trade concerns but now appear oversold. Long-term, diversified U.S. investors seeking exposure to non-dollar assets may find that current EM valuation levels represent an attractive entry point.