Investors “steel” themselves for further volatility
Brian Nick, Chief Investment Strategist, TIAA Investments
The past week’s market highlights:
Quote of the week:
“Michael, we’re bigger than U.S. Steel.” – Hyman Roth to Michael Corleone, in “The Godfather, Part II.”
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: Will higher taxes meet a more hawkish Fed?
President Trump has long favored trade protectionism, so his March 1 announcement of plans to raise taxes on steel and aluminum imports wasn’t a complete surprise. Also not surprising was the market’s immediate reaction: Treasury yields and broad equity indexes fell. Steel-producers rallied, while steel consuming companies, which dwarf steel producers in number and size, suffered on the prospect of higher input costs
If these tariffs take effect, our major trade partners—including China and the Eurozone, neither of which sells us much steel—may start to put countermeasures in place.
The inflation produced by a higher tax typically does not concern the Fed, which tends to view it as a one-time positive price shock rather than a sustained increase in prices. Slower real growth resulting from such a levy may draw the Fed’s scrutiny, however.
For now, the Fed seems satisfied with the health of the U.S. economy. On February 27, the first of his two-day, semiannual monetary policy report to Congress, new Fed Chair Jerome Powell stressed that U.S. economic conditions have improved significantly since the Fed’s December forecasts. He also noted that some of the headwinds faced by the U.S. in previous years have become tailwinds, as fiscal policy has become more stimulative and foreign demand for U.S. exports has firmed.
Amid concerns that the Fed will boost its economic and rate-hike forecasts at its March 21 meeting, the S&P 500 Index fell a combined 2.3% on February 27-28, bringing its loss in February to 3.6%. Indeed, we believe the Fed’s next “dot-plot projections” will show that officials, on average, expect four rate hikes this year, up from three in December.
Turning the calendar did little to quell the market’s turbulence. During the first two days of March, the S&P 500 fell another 0.8% as the announcement of steel and aluminum tariffs sparked fears of a potential trade war.
The past few weeks’ volatility, while unsettling for investors, isn’t unusual given that stocks often encounter difficulty adjusting to environments punctuated by higher growth and inflation. This is especially true if the Fed seems intent on normalizing monetary policy more quickly.
On a positive note, U.S. stocks are trading at their lowest multiples in over a year. Moreover, we remain encouraged by the significant increase in global corporate earnings growth and the widespread economic acceleration taking hold in developed and emerging markets alike. These solid fundamentals should support higher equity prices.
In fixed-income markets, U.S. Treasuries were relatively calm during the past week. The yield on the bellwether 10-year note fell just 2 basis points (0.02%), to close at 2.86% on March 2. Since jumping 44 basis points from January 1-February 2, when it reached 2.84%, the 10-year yield has remained largely rangebound, as the prospects for sharply higher inflation stay low.
At the other end of the Treasury curve, the yield on the 2-year note eased back after touching a 9-year high of 2.27% in the aftermath of Chairman Powell’s testimony. The 2-year security, which is highly sensitive to Fed policy, has been on a steady climb since last September, reflecting expectations of a more aggressive path of rate hikes. Meanwhile, among non-Treasury sectors, returns were strongly positive for the week through March 1, led by mortgage-backed and commercial mortgage-backed securities.
U.S. economy: Tax reform could help hard data catch up
After the 2016 U.S. election, a jump in ”soft” data—generally consisting of survey measures such as consumer sentiment or purchasing manager indexes (PMIs)—reflected improving optimism about the economy. In contrast, “hard” data, which quantifies actual spending and production activity (for example, GDP, retail sales, or industrial production) was not quite as robust. By March 2017, consumer and business optimism spiked, foreshadowing an increase in consumer spending and private capital investment toward the end of last year. That said, soft data hasn’t always been the best predictor of where hard data is heading. At best, results have been mixed.
It’s notable that the past week’s releases of February soft data showed manufacturing, homebuilder, and consumer confidence indexes coming in at or near their cyclical highs. At the same time, some of the week’s hard data releases (such as durable goods and home sales) lagged, while personal spending was up only slightly. But 2018 is still young, and because of the lag necessary to compile actual economic output, the most recent hard data is only from January.
While we believe the economy is unlikely to expand at the torrid pace suggested by the soft data, 2018 GDP growth is very likely to improve upon the 2.3% rate recorded in 2017. Some of the underlying components of the survey data, such as the jump in both employment and prices paid within the ISM Manufacturing index imply that the labor market is tight. This indicates an economy that is heating up as it reaches the final stage of its expansion. And certain provisions in the new tax code provide incentives for that final stage to extend longer than usual. Higher capital expenditures should lift business investment in 2018 and 2019, and consumer spending may ramp up as after-tax disposable incomes rise. Despite what appears to be a somewhat slow first quarter, these potential boosts could help U.S. GDP reach the elusive 3% growth rate for the full year.
